What Drives House Prices?

Abstract

House prices have more than tripled since 1992. After having fallen during the last part of 2002 and the beginning of 2003, house prices rose by more than 20 per cent from May 2003 to November 2004. We analyse factors underlying the pronounced rise in house prices using an empirical model. We find that interest rates, housing construction, unemployment and household income are the most important explanatory factors for house prices. The analysis indicates that house prices react quickly and strongly to changes in interest rates. Thus, a considerable portion of house price inflation since May 2003 can be explained by the fall in interest rates in the last two years. Conversely, the fall in interest rates will only make a modest contribution to house price inflation in 2005. An interest rate increase in line with the interest rate path in Inflation Report 3/04 can in isolation lead to a 3-3½ per cent fall in house prices per year in 2006 and 2007. However, this interest rate path reflects an expected decline in unemployment and an expected increase in the growth of wage income. The model implies that house prices will increase by 2-4 per cent per year in the period 2005-2007 if interest rates, unemployment, income and housing construction develop in line with the analyses in Inflation Report 3/04. We find no evidence that house prices are overvalued in relation to a fundamental value determined by interest rates, income, unemployment and housing construction.