Hedonic Price-Rent Ratios, User Cost, and Departures from Equilibrium in the Housing Market

Departures of the housing market from equilibrium can be detected by comparing the actual price-rent ratio with the user cost of owner occupying. Empirical implementation of this idea, however, is problematic for two reasons. First, the price-rent ratio needs to be quality adjusted. Second, the expected capital gain – an important input into the user cost formula – is not directly observable. Using a large data set for Sydney-Australia, we show how these problems can be resolved using hedonic methods. Otherwise the user cost approach can generate highly misleading results.