Are Housing Price Cycles Driven by Irrational Expectations?

Abstract

This paper investigates the extent to which condominium apartment prices are set in an efficient asset market. Unlike previous work that focuses on the time series properties of measures of excess returns, the analysis is framed in terms of the changes of observable house prices over time. More precisely, the paper develops and applies a test of the joint null hypothesis of rational expectations, perfect markets and no risk premium in the Vancouver condominium apartment market. The empirical results provide significant evidence against the joint null hypothesis. On average, ex post house price changes move in the opposite direction than their rational expectation. This approach offers a methodological advantage over the standard efficiency literature, and is shown to provide a more powerful test of market efficiency than conventional return regressions. Another contribution of the paper is to characterize the time series properties of deviations of condominium prices from those predicted by the risk neutral expectations model, using cointegration and random coefficients techniques. Deviations of house price changes from their (risk neutral) rational expectations are time-varying, stationary, and related to the stage of the real estate price cycle.

JEL Classification: R21, R31