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

Abstract

The paper explores how the standard consumption-CAPM fares in pricing housing returns and regional rental income streams in a cross-section of regions. In particular, the paper estimates the Euler equations associated with the gross housing returns inclusive of house price appreciations and rents jointly for several metropolitan areas of the United States. The representative agent has a Constant Relative Risk Aversion utility function. The rent growth is allowed to depend on the lagged Chicago Fed National Activity Index to capture the business cycle dependence of the rents. When biannual data from 1978 to 2007 is used, the parameter point estimates are reasonable, and the model is not rejected on the basis of the Generalized Method of Moments J-Test. However, the estimates are not very informative since the standard errors can be quite large. When the point estimates from the Euler equations are in turn used to price the rent cash flows in the model, the resulting price rent ratio time series averages are in the same ballpark as the data, however the model completely misses the boom-bust pattern in the prices. In addition, the model significantly understates the average and the variance of the house price appreciations. Results are robust to assuming i.i.d. rent growth rather than predictable. Results also exhibit robustness to allowing housing consumption directly in the utility function as in Piazzesi, Schneider and Tuzel (2007) or using the Epstein-Zin-Weil utility function as in Epstein and Zin (1989) and Weil (1989) instead of the Constant Relative Risk Aversion.

Keywords: Residential Housing, Asset pricing