We investigate the predictive power of the rent-to-price ratio for future real estate returns and rent growth in 18 OECD countries over the period 1970 to 2011. First, we document that in most countries returns are significantly predictable by the rent-price ratio. An increase (decrease) in the ratio signals a future increase (decrease)in returns. Second, there are large cross-country differences in how the rent-price ratio predicts rent growth. For some countries, the direction of predictability is negative, for other countries it is positive. Third, the predictive patterns are highly dependent on whether returns and rents are measured in nominal or real terms. Finally, there is some evidence of sub-sample instability in the predictive patterns, especially wrt. rent growth predictability. The predictability tests are conducted within a restricted VAR framework based on the dynamic Gordon growth model. This model implies restrictions across the VAR parameters that can be used to construct powerful tests of predictability.

Standard textbook models of price determination in real estate markets imply that rents are a fundamental determinant of housing value, similar to the role of dividends in deter-mining equity valuations in stock markets, and the rent-to-price ratio (sometimes denoted) summarizes market expectations of future real estate returns and/or rent growth in the same way as the dividend-price ratio summarizes expectations of future stock returns and/or dividend growth. A number of recent studies have analyzed the predictive power of the rent-to-price ratio for future returns and rent growth in the US real estate market, e.g. Gallin (2008), Palazzi, Torous, and Valkanov (2010), Cochrane(2011), and Ghysels, Plazzi, Torous, and Valkanov (2012). The overall on ding is that the rent-to-price ratio predicts future returns more strongly than it predicts future rent growth, just as the dividend-price ratio appears to be a stronger predictor of returns than dividend growth in the US stock market (Cochrane, 2011).

Whether the rent-to-price ratio predicts future returns or rent growth is of fundamental importance for the interpretation of price movements in real estate markets. The dramatic increase in US house prices up to 2006 (followed by a severe drop) must be due to one of the following three causes (or a combination of them). Either a speculative bubble, changing expectations of future returns (e.g. due to changing risk premia), or changing expectations of future fundamentals. The empirical evidence cited above points to the second of these causes as the most important, although Shiller (2005) argues that an irrational bubble was the main driver, while Himmelberg, Mayer, and Sinai (2005) on the other hand argue that the price increases.