Fundamental Real Estate Prices: An Empirical Estimation with International Data

We propose two alternative models to estimate fundamental prices on real estate markets. Both models state that the fundamental price is the sum of the discounted future period costs that arise from owning a house. The first model is based on a no-arbitrage condition between renting and buying a house. It states that the period costs are equal to the rents. The second model interprets the period costs as the result of a market equilibrium between housing demand and supply. We estimate both models for the USA, the UK, Japan, Switzerland, and the Netherlands. We find that observed prices deviate substantially and for long periods from their estimated fundamental values. However, by studying the dynamics of the gaps, we find some evidence that in the long-run actual prices tend to return progressively to their fundamental values. This fact is supported by a forecast analysis. We find that models including our fundamental prices significantly outperform long-term forecasts made by models based on the observed price dynamic only.