Journal of Real Estate Finance and Economics, 14: 3, 341±363 (1997)
# 1997 Kluwer Academic Publishers
Are Housing Price Cycles Driven by
Department of Finance and Management Science, The Frank H. Sobey Faculty of Commerce,
Saint Mary's University, Halifax, Nova Scotia, Canada B3H 3C3
This paper investigates the extent to which condominium apartment prices are set in an ef®cient asset market.
Unlike previous work that focuses on the time-series properties of measures of excess returns, the analysis is
framed in terms of the changes in observable house prices over time. More precisely, the paper develops and
applies a test of the joint null hypothesis of rational expectations, perfect markets, and no risk premium in the
Vancouver condominium apartment market. The empirical results provide signi®cant evidence against the joint
null hypothesis. On average, ex post house price changes move in a direction opposite to their rational
expectation. This approach offers a methodological advantage over the standard ef®ciency literature and is shown
to provide a more powerful test of market ef®ciency than conventional return regressions. Another contribution of
the paper is to characterize the time-series properties of deviations of condominium prices from those predicted
by the risk-neutral rational expectations model, using cointegration and random coef®cients techniques.
Deviations in house price changes from their (risk-neutral) rational expectations are time varying, stationary, and
related to the stage of the real estate price cycle.
Key Words: rational expectations, market ef®ciency, cointegration, structural change
In recent years many local housing markets have undergone boom and bust cycles. A
number of academics and housing market commentators claim that housing markets are
characterized by excess speculation during real estate market upswings. That is, intangible
expectations lead prices to race ahead of fundamental or intrinsic values, and thus, housing
price booms are driven primarily by irrational house price expectations and investor
psychology rather than wide swings in housing market fundamentals.
This paper provides further evidence on the rationality of house price expectations and
the informational ef®ciency of residential housing markets. It adds to the existing
literature in three ways. First, most tests of housing market ef®ciency use standard
empirical ®nance tools.
That is, researchers either examine the autocorrelation structure
of estimates of excess returns or test whether any variables in the current information set
have predictive power for future excess returns. If the housing market behaves as an
ef®cient asset market then excess housing returns should be uncorrelated over time and
unpredictable with information known at the time forecasts are made.
This study develops and applies a different testing methodology. Rather than work with
excess returns, I use the market ef®ciency condition to generate a measure of expected