Linking House Price and Rent Dynamics: The Role of Supply Constraints

Over the past two decades, the house price-to-rent ratio has risen dramatically in many parts of the world, particularly in supply constrained superstar cities. We provide a theoretical explanation for this phenomenon that does not rely on falling real interest rates, changing credit conditions, unrealistic expectations, rising inequality or global investor demand for superstar cities. A simple model that distinguishes between short- and long-run supply constraints and assumes that housing demand shocks exhibit serial correlation, predicts that (i) if supply is sufficiently constrained and serial correlation sufficiently strong the price-to-rent ratio increases in response to a positive initial demand shock (otherwise it decreases), (ii) this effect is more pronounced when local supply is more constrained, (iii) the price-to-rent ratio always decreases in response to a negative demand shock, and (iv) because of the durability of housing, the latter effect is independent of supply constraints. Employing panel data for 353 Local Planning Authorities in England from 1997 to 2018, we provide evidence in support of all four predictions. Our estimates suggest that in Greater London, where supply is seriously constrained, local labor demand shocks in conjunction with supply constraints explain 63% of the increase in the price-to-rent ratio since 1997. Macroeconomic factors explain 37%. The picture is reversed outside of Greater London, where macroeconomic factors explain the bulk (84%) of an albeit much smaller increase. Joint with Andreas Mense (Friedrich-Alexander University Erlangen-Nuremberg).