The role of fundamentals in house price variation

This paper uses a competitive-equilibrium housing market to evaluate the role that interest rates and demand growth have played in the U.S. cycle of house-price variation in the twenty-first century. Although some cities experienced huge price changes during this period, in other cities house-price variation has been relatively modest.  This paper investigates the cause of the house-price cycle and its different characteristics across different cities in the U.S..  It does so by exploring the determinants of house prices; thus treating them as endogenous to the fundamental factors of interest rates, demand and construction costs, as well as geographic features of the cities. The model has markets for each of undeveloped land, housing construction and developed houses. It has stochastic interest rates, stochastic demand and construction costs. It has regime-switching stochastic processes that provide the flexibility for there to be stable outcomes and expectations of the future that may persist for periods of time, while at the same time admitting the possibility of rapid change. The value of unimproved land is the value of the option to build given stochastic interest rates and demand; construction commences when the expected payoff to construction exceeds the value of the option value to delay building. The model is calibrated to U.S data and it produces the supply of developed land and house prices over time, without using house prices directly.  Unimproved land quality, and regulation demand vary across cities in the model. The model shows how local geography and expectations significantly explain house-price fluctuations over time.