Bubble, Bubble, Where’s
the Housing Bubble?
HOUSING PRICES HAVE risen by about 50 percent in the past five years,
and more than 100 percent in some hot markets. Many knowledgeable
observers believe that the United States is in the midst of a speculative
bubble in residential real estate prices that rivals the dot-com bubble of
the 1990s and that will have a similarly unhappy conclusion.
In December 2004 UCLA Anderson Forecast’s Economic Outlook
described the California housing market as a bubble, repeating their warn-
ings made in previous years. Robert Shiller has issued similar alarms for
several years and, in June 2005, warned that, “The [housing] market is in
the throes of a bubble of unprecedented proportions that probably will end
ugly.”1 Shiller suggests that real housing prices might fall by 50 percent
over the next decade. In August 2005 Paul Krugman argued that there
was definitely a housing bubble on the coasts and that, indeed, the air
had already begun leaking out.2
Evidence of a housing bubble has been suggestive but indirect, in that
it does not address the key question of whether housing prices are justified
by the value of the services provided by a home. We first show how to
estimate the fundamental value of a home from rent data. We then use this
procedure to estimate the fundamental value of homes in ten urban housing
M A R G A R E T H W A N G S M I T H
G A R Y S M I T H
This research was supported by the John Randolph Haynes and Dora Haynes Founda-
tion. We are grateful to Alan Blinder, Brian Chew, Jay Daigle, Daniel Harding, Edmund
Helmer, Jesse Licht, Steve Marks, Christopher Mayer, Thomas Renkert, John Romeo,
Samuel Ross, and Robert Shiller for their assistance and many helpful comments.
1. Robert Shiller, “The Bubble’s New Home,” Barron’s, June 20, 2005.
2. Paul R. Krugman, “That Hissing Sound,” The New York Times, August 8, 2005.
markets using a unique set of rent and sale price data for matched single-
family homes. Our evidence indicates that, even though prices have risen
rapidly and some buyers have unrealistic expectations of continuing price
increases, the bubble is not, in fact, a bubble in most of these areas: under
a variety of plausible assumptions about fundamentals, buying a home at
current market prices still appears to be an attractive long-term investment.
Our results also demonstrate that models that gauge a housing bubble
by comparing movements in housing price indexes with movements in
other indexes or with the values predicted by regression models are flawed,
because they assume that market prices fluctuate randomly around funda-
mental values. Those models must assume that prices were close to funda-
mentals in the past in order to conclude that the 2001–05 run-up pushed
prices above fundamentals. But maybe prices were below fundamentals in
the past and the 2001–05 run-up pushed prices closer to fundamentals.
Defining a Bubble
Charles Kindleberger defined a bubble this way:
a sharp rise in price of an asset or a range of assets in a continuous process,
with the initial rise generating expectations of further rises and attracting
new buyers—generally speculators interested in profits from trading in the
asset rather than its use or earning capacity. The rise is usually followed by
a reversal of expectations and a sharp decline in price often resulting in
Researchers often focus on a single specific aspect of this general con-
cept: rapidly rising prices,4 unrealistic expectations of future price
increases,5 the departure of prices from fundamental value,6 or a large
drop in prices after the bubble pops.7
Shiller and Karl Case write that, “A tendency to view housing as an
investment is a defining characteristic of a housing bubble.”8 To the con-
trary, we believe that housing is an investment and that the correct way to
gauge a bubble is to compare actual home prices with the value of homes
2 Brookings Papers on Economic Activity, 1:2006
3. Kindleberger (1987, p. 281).
4. Baker (2002).
5. Case and Shiller (2003).
6. Garber (2000).
7. Siegel (2003, p. 3).
8. Case and Shiller (2003, p. 321).
as an investment calculated from fundamentals (and that one of the main
sources of mispricing in the housing market is that almost none of the par-
ticipants estimate the fundamental value of their home).
We define a bubble as a situation in which the market prices of certain
assets (such as stocks or real estate) rise far above the present value of the
anticipated cash flow from the asset (what Kindleberger called the asset’s
use or earning capacity). This definition suggests many of the features
noted above: prices rising rapidly, a speculative focus on future price
increases rather than the asset’s cash flow, and an eventual drop in prices.
However, these features are only suggestive. Market prices can rise rapidly
if fundamental values are increasing rapidly or if prices are far below fun-
damental values. Market prices can drop (for example, in a financial crisis)
even when there has been no bubble. What truly defines a bubble is that
market prices are not justified by the asset’s anticipated cash flow.
Is the Housing Market Efficient?
True believers in efficient markets might deny that there can ever be a
bubble. The market price is always the correct price and is therefore jus-
tified by the expectations market participants hold. Even Jeremy Siegel,
who believes there can be bubbles, writes that “We know that the price of
any asset is the present value of all future expected cash flows.”9 Contrast
this with the opening sentence of John Burr Williams’ classic treatise, The
Theory of Investment Value: “Separate and distinct things not to be con-
fused, as every thoughtful investor knows, are real worth and market
price.”10 In the stock market these two arguments can perhaps be recon-
ciled by a consideration of whether the anticipated cash flows that
investors use to calculate present values are reasonable. One way in which
the residential real estate market is fundamentally different is that home-
buyers generally do not calculate present values.
Case and Shiller report survey evidence of homeowners’ naivety
about the real estate market.11 The residential real estate market is popu-
lated by amateurs making infrequent transactions on the basis of limited
information and with little or no experience in gauging the fundamental
value of the properties they are buying and selling. It is highly unlikely
Margaret Hwang Smith and Gary Smith 3
9. Siegel (2003, p. 3, emphasis in original).
10. Williams (1938, p. 3).
11. Case and Shiller (2003).
that residential real estate prices are always equal to the present value of
the expected cash flow if market participants almost never attempt to esti-
mate the present value of the expected cash flow.
Instead, the nearly universal yardstick in residential real estate is
“comps,” the recent sale prices of nearby homes with similar characteris-
tics. Comps tell us how much others have paid for homes recently, but not
whether these prices are justified by the cash flow. Is a Britannia the
British Bear Beanie Baby worth $500 because a Princess Beanie Baby sold
for $500? Is this house worth $1 million because a similar house sold for
$1 million? The widespread use of comps by buyers, sellers, real estate
agents, and appraisers is the very mechanism by which market prices
can wander far from fundamental values. If no one is estimating funda-
mental value, why should anyone assume that market prices will equal
In the stock market, professional investors can, in theory, arbitrage and
exploit the mistakes made by noise traders. In the housing market, how-
ever, professionals cannot sell homes short and cannot obtain the tax
advantages available for owner-occupied housing by physically occupying
multiple homes. It is also expensive to manage and monitor rental proper-
ties, especially from afar. If a myopic focus on comps causes housing
prices to depart from fundamentals, there is no immediate self-correcting
In such an inefficient market, prices can be above or below fundamen-
tal value. Housing bubble enthusiasts implicitly assume that market prices
were, on average, equal to fundamental values in the past in order to con-
clude that recent increases have pushed prices above fundamental values.
Perhaps, instead, housing prices were too low in the past and recent price
increases have brought market prices more in line with fundamentals.
Researchers have used a variety of proxies to gauge whether there is a
bubble in the real estate market. One pervasive problem is the reliance on
aggregate measures of housing prices that are notoriously imperfect, for
several reasons: homes are heterogeneous in their characteristics and loca-
tion; it is difficult to measure the depreciation of existing properties or the
value added by remodeling; and it is difficult to measure changes in the
quality of home construction over time. Jonathan McCarthy and Richard
Peach show that, between 1977 and 2003, four popular home price indexes
4 Brookings Papers on Economic Activity, 1:2006
differed markedly in their estimates of price appreciation, ranging from
199 percent (constant-quality new homes) to 337 percent (median sale
price for existing homes).12
Even if the price indexes were perfect, their application is questionable.
For example, Case and Shiller look at the ratio of housing prices to house-
hold income, the idea being that housing prices are a bubble waiting to pop