Most U.S. cities show little evidence of a housing bubble as of the end of 2004, according to a study by two prestigious universities released today.

Recent house-price jumps are largely explained by economic fundamentals such as low interest rates, strong income growth and unusually low housing prices in the mid-1990s, said a study of 46 single-family housing markets from 1980 to 2004 by researchers from Columbia Business School, the Federal Reserve Bank and the Wharton School of the University of Pennsylvania.

The study, “Assessing High Housing Prices: Bubbles, Fundamentals and Misperceptions,” found no evidence that buyers are bidding up the price of houses based on unrealistic expectations of future price increases.

According to the study, conventional metrics for assessing the housing market such as price-to-rent ratios or price-to-income ratios ignore the effects of lower real, long-term interest rates, and thus fail to accurately reflect the state of housing costs.

The study sought to dispel what it called common misperceptions, such as:

Misperception #1: The rising price of housing necessarily means that ownership is becoming more expensive.

According to the study, the price of a house is not the same as the annual cost of owning a house. The study calculated the actual cost of owning a house relative to rents and incomes, and found that these ratios were well within historical norms at the end of 2004.

According to the study, during the mid-1990s, housing prices were somewhat undervalued, and at least part of the increase in house prices over the past 10 years reflects a return of these valuation ratios to long-run historical norms.

Misperception #2: High house price growth implies a bubble.

The study said that when the real cost of long-term borrowing is low, as it is today, changes in long-term interest rates have a disproportionately large effect on house prices. Thus, given the decline in real, long-term interest rates since 2000, it is not surprising that house prices have risen as much as they have, according to the study.

However, the other side of the coin is that the housing market may be especially vulnerable to unexpected future rises in real, long-term interest rates or negative shocks to local economies, the study said.

Misperception #3: The cities with the highest price increases (or the highest price-to-rent ratios) are the most overvalued.

In some local housing markets such as San Francisco, Los Angeles, San Diego, New York and Boston, house-price growth has exceeded the national average rate of appreciation for at least 60 years, the study said.

But, according to the study, in cities with higher long-term rates of price appreciation, the annual cost of owning is lower; hence house prices should be higher (relative to rents or incomes). At the same time, house prices in high-priced cities are more sensitive to real, long-term interest rates because interest expense is a higher fraction of annual ownership costs, the study said.

The study concluded that the current U.S. housing values are consistent with strong economic fundamentals. The reduction in ownership costs caused by lower real, long-term interest rates, in particular, has largely offset the rise in housing prices, the study said.

However, the study also cautions that when real, long-term interest rates are already low, further changes in rates can have a disproportionately large impact on the housing market. An unexpected rise in real interest rates or a negative shock to household incomes could cause house prices to decline, according to the study. But this fact does not mean that today houses are systematically mis-priced, according to the study.


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