- Comments and Discussion
Before reading this paper by Margaret Hwang Smith and Gary Smith, I would have thought that almost any paper on which Robert Shiller and I were the discussants would have fallen somewhere between the two of us in its judgment on whether a housing bubble exists in the United States today. I recently wrote a paper with Charles Himmelberg and Todd Sinai that argues that there is not a housing bubble in most metropolitan markets, and that the cost of housing in most markets is close to its twenty-five-year average.1 Shiller, in contrast, has been outspoken about the possibility of a housing bubble. It turns out, however, that Shiller and I do not span the spectrum of views on this issue: the evidence in this paper suggests that housing in many parts of the country remains cheap. After the recent long and pronounced run-up in prices, I am surprised by this conclusion.
The question is one of both economic importance and social interest. Any article in any section of The New York Times or The Wall Street Journal that has the word "housing" in the title will likely be the top e-mailed article of the day. Even an op-ed on housing that I published in The Wall Street Journal turned out to be the top e-mailed article that day. Three years ago Karl Case and Shiller used a Lexis-Nexis search to demonstrate that the use of the words "housing bubble" and "housing boom" had reached record highs in major media publications.2 And things have become crazier since then. [End Page 51]
So how does one know if there's a housing bubble? In corporate finance, where data are much more readily available than for single-family houses, researchers determine whether the value of a firm is reflected in its stock price by comparing the latter to the net present value of projected earnings, dividends, or cash flow. Of course, economists argue over what is the right measure of cash flow and the right discount rate, how the risk premium varies over time, and so forth. But the basic concept of discounted net present value is widely accepted. Therefore what this paper is doing has to be right in some reasonably efficient real estate market. The problem is that many researchers have argued that real estate markets are far from efficient.
Application of the NPV relationship to housing has been hindered by the fact that it is difficult to observe rents for single-family homes. To compensate, researchers often use home price indexes, which, thanks to the pioneering research by Case and Shiller,3 have become much more easily available.
To begin, I think the paper could benefit from a more complete summary of the academic literature, to get a better perspective on this research. For example, James Poterba pioneered the user cost framework for valuing housing.4 This is the same framework that financial economists use to evaluate corporate investment, and it is closely related to an after-tax NPV analysis. Since then the user cost framework has been used in many analyses of housing, and it is not really so different from what the authors do here. Alternatively, Richard Meese and Nancy Wallace explicitly evaluated the present value relationship that the authors use here for a sample of homes in various communities in Northern California, although unlike the present authors they did not have a matched sample of rents and sale prices.5 Meese and Wallace concluded that home sale prices were above fundamental values in the late 1980s.
Other economists, such as Case and Shiller,6 look at imputed mortgage payment-to-income ratios and price-to-income ratios to get a rough idea of whether homes are overpriced. I would argue, however, that such measures are not great at measuring mispricing, because they do not reflect changes in interest rates, which surely ought to affect the value of any [End Page 52] long-lived asset such as a home. Urban economists sometimes argue for an alternative measure that compares home prices with construction costs when the price...