Hedonic price-rent ratios, user cost, and departures from equilibrium in the housing market

Departures from equilibrium in the housing market can be detected by comparing the actual price-rent ratio with the price-rent ratio derived from the user cost equilibrium condition. The equilibrium price-rent ratio, however, assumes that the sold and rented dwellings being compared are of equal quality, which is typically not the case. Using hedonic methods applied to prices and rents for 730,000 houses in Sydney, Australia, we find that quality-adjusting reduces the actual price-rent ratio by on average 18%. Failure to make such a correction therefore will seriously bias the results towards a finding that the price-rent ratio is above its equilibrium level. We also explore ways of imputing the expected capital gain - a key input into the equilibrium price-rent ratio formula, and show that price-rent ratios (both actual and equilibrium) vary in systematic ways over the housing distribution. This latter result implies that it is not enough to simply focus on the median, as different results may pertain for other quantiles. (C) 2015 Elsevier B.V. All rights reserved.