Hedonic price–rent ratios, user cost, and departures from equilibrium in the housing market

• Hedonic quality-adjustment reduces the price–rent ratio by on average 18%.
• The size of the hedonic adjustment to the price–rent ratio varies over time.
• The user cost method is sensitive to the treatment of expected capital gains.
• Both actual and equilibrium price–rent ratios are higher at the top end of the market.
• The price–rent ratio in Sydney was 50% above its equilibrium level in 2004.

Departures from equilibrium in the housing market can be detected by comparing the actual price–rent ratio with the price–rent ratio derived from the user cost equilibrium condition. The equilibrium price–rent ratio, however, assumes that the sold and rented dwellings being compared are of equal quality, which is typically not the case. Using hedonic methods applied to prices and rents for 730,000 houses in Sydney, Australia, we find that quality-adjusting reduces the actual price–rent ratio by on average 18%. Failure to make such a correction therefore will seriously bias the results towards a finding that the price–rent ratio is above its equilibrium level. We also explore ways of imputing the expected capital gain – a key input into the equilibrium price–rent ratio formula, and show that price–rent ratios (both actual and equilibrium) vary in systematic ways over the housing distribution. This latter result implies that it is not enough to simply focus on the median, as different results may pertain for other quantiles.