Can Housing Prices be Justified by Economic Fundamentals? Evidence from Regional Housing Markets in Korea

Abstract

In this study, we use a present-value approach to examine the dynamics of six regional housing markets in Korea. The large upswing in the price–rent ratio accompanied by intermittent ups and downs, which are typical features of the Korean housing market since the mid-1980s, is captured by a periodically collapsing bubble incorporated into an otherwise standard present-value model. The movements in the actual price–rent ratio are then decomposed into movements explained by the expectations of housing market fundamentals (i.e., rent growth, risk-free interest rate, and excess returns from housing investment) and the speculative bubble. In all the six regional markets, most of the variations in the fundamental part of the price–rent ratio are explained by the expected risk premium of housing investment and the expected risk-free returns, whereas the expected rent growth account for relatively small fractions of the variations. The bubble has continuously accumulated since the early 2000s in all the six regions and has reached as high as 70% of house price by the end of 2017.