The Changing Relationship between UK Home Prices and Rents

The present value models of house prices predict that house prices and rents are related via a stable price-to-rents ratio, as house prices are equal to the present discounted values of future rents. The prolonged divergence of the UK house prices from rents since the mid-1990s has put into question the stability of the price-rents relation. In this paper, we reexamine the changing relationship between house price and rents using a Markov-switching error correction model, and we find two distinct regimes in the price-rents relation. In one regime, which is identified mainly in the pre-1988 era, the long-run equilibrium relationship corresponds to the prediction of the present value models, i.e., the stable price-to-rents ratio. The other regime, prevailing since 1988 forward, also involves a stationary price-rents relation. As such, this regime is not characterized with speculative bubbles. However, the long-run relation in this regime is difficult to explain by the present value models, and the identified regime period exhibits a long swing in the price-rents ratio.