The Long-Run Relationship between
House Prices and Rents
Joshua Gallin, Federal Reserve Board 
February 2005
I show that when house prices are high relative to rents (that is,
when the rent-price ratio is low) changes in real rents tend to be
larger than usual and changes in real prices tend to be smaller than
usual. Standard error-correction models provide inconclusive results
about the predictive power of the rent-price ratio at a quarterly
frequency. I use a long-horizon regression approach to show that the
rent-price ratio helps predict changes in real rents and real prices
over three-year periods. This result withstands the inclusion of a
measure of the user cost of capital. I show that a long-horizon
regression approach can yield biased estimates of the degree of error
correction if prices have a unit root but do not follow a random walk.
I construct bootstrap distributions to conduct appropriate inference
in the presence of this bias. The results lend empirical support to
the view that the rent-price ratio is an indicator of valuation in the
housing market.

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