Pricing the Us Residential Asset Through the Rent Flow : A Cross-Sectional Study

A calibrated Lucas (1978) style dynamic exchange economy to value the U.S. rental residential properties through the rent cash slows can match the cross-section of the average price-rent ratios from 1978 to 2007 with reasonable parameter values. However, from the view point of this calibration the period from 2002 to the end of 2007 appears severely overpriced. The model significantly understates the time series volatility of the prince-rent ratios and the average rate of price appreciation and overstates the volatility. Recalculating the economies with conservatively calibrated transaction costs for the housing asset using the appropriate procedure in He and Modest (1995) mean that the average price-rent ratios can assume any value within a large range which typically includes the half and twice the empirical average price-rent ratio. Results exhibit robustness to simplifying the rent growth rate as an i.i.d. process or allowing for Kreps and Porteus (1978) utility rather than Constant Relative Risk Aversion (CRRA). Moreover, about a third of the large cross-sectional variation in overpricing from 2002 to 2007 can be explained by the various dimensions of the regional subprime lending activity, one at a time: no or low documentation loans, origination year (2005 and before, 2006 and 2007), cash-out refinances, ARM loans and borrower FICO scores. In addition, the cross-section of average overpricing can predict the magnitude of the regional house price depreciations from 2007 until the third quarter of 2008 with more than 30% R-squared