Understanding the cross-section of the U.S. housing bubble: The roles of lending, transaction costs, and rent growth

This paper establishes baseline valuations for housing assets using rent cash flows in 22 regions of the U.S. in a Lucas (1978) framework. The model matches the unconditional averages of the price–rent ratios from 1978 to 2012 quite well; however, the model valuations after 2002 are well below the market price–rent ratios. We explore three mechanisms to understand these housing overvaluations in the post-2002 period relative to the consumption-based model: (1) using cross-sectional subprime consumer and commercial lending characteristics; (2) transaction costs; and (3) turning off the pro-cyclicality of the rent growth in the data. We find that all three factors explain some fraction of the bubble in valuations, but none alone is enough to understand the full extent of post-2002 valuations.