Empirical testing

equals the cost of foregone interest that a homeowner may have earned on alternative investments.

• Property tax rate: Property tax is an optional tax form in Norway, which only some municipals apply, and the tax rate varies. However, OECD assumes the property tax rate of owner-occupied houses to be fixed at 0.7 % in their calculations (Girouard, 2006).

• Expected capital gains: Expected capital gains (or loss) on the house is calculated by the OECD methodology as a moving average of the CPI over the previous five years (Girouard, 2006).

• Depreciations: OECD assumes depreciations to be fixed at 4 % (Girouard, 2006).

Figure 7.9: P/R rates in Norway 1871-2015

Figure 7.9 illustrates the development from 1871 to 2016. The analysis shows an overall rising trend. However, fluctuations are to be seen during the whole period, especially during the economic crises and previous housing bubbles. We will now go deeper into the development in the relationship between house- and rental prices in the period from 1871 to 2016. However, since the aim of this thesis is to investigate whether there are bubble tendencies in the Norwegian housing market today, we will focus on the latest decades.

The formation of the “Kristianiakrakket”, which later burst in 1899, as well as disturbances associated with The Great War (1914 - 1918), is clearly illustrated in figure 7.9. The period from 1930 to 1980 shows a relatively flat trend, despite some short-term fluctuations in the coefficients.

In order to study the latest period more accurately, we have chosen to display the P/R development from 1980 to 2016 with a log linear trend line:

Figure 7.10: P/R with and exponential trend line 1980-2016 in Norway

Figure 7.10 illustrates a relatively steady increase in the P/R ratios since 1980, with exceptions from the crash in 1987 and the fall in house prices during the financial crisis in 2008. As illustrated, the formation of a new housing bubble from the mid-1980s is evident. The house prices reached a peak in the late 1980s, followed by a sharp decrease (burst) due to the housing market crash with significant fall in prices. By using the exponential trend line, we can see that the real P/R ratios were much higher than the trend ahead of the housing market crash, and lower than the trend during the crash. The 1980s were characterized by major economic upheavals. In addition, people had high optimistic expectations for the future as a result of the credit market liberalization, increased wages and low real interest rates. This triggered both consumption and demand in the country, and household’s debt ratio as well as house prices grew, as shown in figure xx.

This took an abrupt end in 1987-1988. The increase in housing prices turned out not having root in fundamental factors, and a sudden drop in oil prices, economic setbacks and subsequent rising unemployment, caused a recession in the national economy. Economic disturbances spread quickly through to the housing market, and the bubble burst was fact. Both real and nominal house prices were facing a period with negative growth, which lasted nearly six years.

In 1992, nominal house prices bottomed out at a P/R ratio of 8.17. Since rental housing had become relatively more expensive compared to owner-occupied housing as a result of the decline in house prices, the demand for owner-occupied housing gradually began to pick up again. As a result of a new economic upturn combined with optimistic future expectations among the general public, the demand for owner-occupied housing increased. Consequently, housing prices grew rapidly in the 1990s. As illustrated in the figure, the relationship between house- and rental prices increased steadily.

The rise in house prices began to level out in the beginning of the new millennium. Calculations of the P/R ratios show a growth from 2002 to 2003 of only 0.55 %. This was probably a consequence of a technology bubble that burst around the millennium, combined with fear of terrorism following the September 11 attacks in 2001, and thus less optimistic expectations. However, from the second half of 2003, the house price growth really speeded up, with relatively high P/R values compared to the levels in the 1980s. We have chosen to illustrate some selected P/R values in the table below, with both individual values, and the average P/R rate for the period as a whole:

Avg. price per m² 1980-2016 1980 1987 1992 2003 2008 2016 House price 14 245 2 590 7 929 5 543 15 187 22 854 34 506

Rental price 746 283 519 678 862 929 1 092

Real P/R ratio 17.20 9.14 15.27 8.17 17.62 24.61 31.61

Table 7.1: Real P/R ratios in selected years in Norway

As illustrated in table 7.1 and in figure 7.10, there has been a tremendous development in P/R rates since 1980. Despite of a slight fall around the 2000s and the financial crisis in 2008, the values have been rising sharply. Table 7.1 clearly shows that today’s P/R value is at a relatively high level compared with the average level for the entire period between 1980 and 2016.

In addition, figure 7.10 shows large positive deviations from the trend prior to the financial crisis, as well as rising deviations until the present. However, with an explanatory power of only 76 % of the data, the trend line must be used a bit careful. It is however clear that the P/R values are, and have

been, on a much higher level than previous periods. Additionally, we find it interesting that the P/R value today is at 31.61, which is a higher level than what it was during the top of the previous housing bubble in 1987, when it was 15.27 at its highest. The figure also illustrates more than a threefold increase in P/R values in the period between 1993 and 2016. This indicates that it was more than three times as expensive to buy a house relative to rent a house today as in 1993. The strong growth in P/R coefficients in the past 20 years may indicate existence of a bubble in the housing market, which is amplified if one assumes that the current values are of a much higher rate than what they were in the late 1980s during the course of the banking crisis.

High P/R values in the housing market can, as previously mentioned, partly be justified, as homeownership is heavily tax-favored. However, there have not been any major changes in the taxation rules the last 20 years. Thus, changes in taxation rules could not be said to be a strong argument when explaining the sharp rise in the P/R ratios. Nevertheless, as mentioned in section 6.1 of Case and Shiller’s seven criteria regarding the existence of housing bubbles, expectations of a continuing rise in housing prices appears to be present. However, high expectations of a continuing increase in housing price will not in itself be enough to explain or defend the high P/R values. Nor is there any quantitative size of the P/R ratio that states whether house prices are overrated, but the ratios may provide indications of house prices´ future development.

To provide a deeper analysis of developments in house prices by using P/R values, we have to calculate what the real P/R ratio should have been for the market to be in equilibrium. Hence, it is desirable to compare the real P/R ratios with the fundamental P/R ratios. As mentioned above, a high positive difference over time may provide an indication of a possible bubble formation.

Fundamental P/R ratios

To calculate the fundamental P/R ratios, we have used the right side of equation (7.3). This gives us the following table and calculations of fundamental P/R:

Year 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Nominal

borrowing rate

3.92% 4.26% 5.66% 7.29% 4.91% 4.52% 4.75% 4.84% 4.75% 4.61% 3.93%

Tax rate 28% 28% 28% 28% 28% 28% 28% 28% 28% 27% 27%

= After-tax nominal mortgage interest rate

3% 3% 4% 5% 4% 3% 3% 3% 3% 3% 3%

Property tax 0.70% 0.70% 0.70% 0.70% 0.70% 0.70% 0.70% 0.70% 0.70% 0.70% 0.70%

Expected capital gains (loss)

1.61% 1.50% 1.77% 2.10% 2.26% 2.08% 2.06% 1.74% 1.72% 1.67% 1.77%

Depreciations 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4%

Fundamental P/R ratios

16.90 15.96 14.28 12.75 16.75 17.01 16.50 15.53 15.63 15.64 17.25 Real P/R ratios 20.98 23.80 25.89 24.61 24.35 25.82 27.49 29.22 30.44 29.79 31.25 Table 7.2: Calculations of fundamental P/R ratios in Norway

Actual versus fundamental P/R

We can now study the development of real- versus fundamental P/R values. This is done for the period from 1990 to 2015. We do not go further back in time, as the last decades are most expedient.

In addition, OECD did not go further back than 1990 in their report (Girouard, 2006). The trend can be seen in the figure below:

Figure 7.11: Real- and fundamental P/R rations in Norway

Figure 7.11 illustrates higher real P/R ratios than fundamental ratios since 1998. A possible explanation for lower fundamental ratios may be lower nominal borrowing rates, while expected capital gains are higher, at least until 2012. These two factors may have equalized each other. Lower nominal interest rates will also result in increased house prices, due to higher housing demand, according to section 3.5.1.

The gap between real- and fundamental P/R ratios was at its largest in 2007-2008. At this time, the real P/R ratio was equal to 25.89, compared to the fundamental P/R ratio of 12.75. This may be due to the strong growth in house prices between 2003 and 2007, while the nominal borrowing rate increased within the same period. Higher interest rates reduced the fundamental P/R ratios, whereas higher house prices increased the real ratios. In the period between 2008 and 2009, these two elements moved towards each other. Lower house prices may have resulted in lower real P/R ratios, while reduced interest rates have increased the fundamental ratios. The fundamental ratios have remained relatively stable with a slight decrease after 2009, while the real P/R ratios have continued to increase. This indicates a bubble accumulation and is a consequence of low interest rates the past seven years in parallel with rising house prices.

Conclusion P/R analysis

We have investigated whether Norway has tendencies of being in a housing bubble or not, by looking at deviations between real and fundamental values. Our findings show a high growth in the real P/R ratios since the early 1990s. This growth, which has resulted in a higher real P/R ratio in 2015 than during the previous housing bubble, provides indications of a housing market being in disequilibrium. Additionally, we found the real P/R ratios to be higher than the fundamental ratios since 1997. Despite the financial crisis, the gap between the real- and the fundamental P/R ratios has increased. The noticeably higher real ratios compared to fundamental ratios indicates an overvaluation of Norwegian house prices. Conclusively, according the P/R model, it is reasonable to believe that Norway has indications of being in a housing bubble.

An obvious weakness of the P/R model is that it does not fully differentiate between “pure”

appreciation in house prices and price changes due to depreciation or improvement of housing

(renovation). This is a challenge in Norway, as no other nation in the world spends more money on house upgrading. Numbers from Prognoscentret shows that the Norwegian population refurbished for more than NOK 70 billion in 2015, which is the highest amount ever recorded in the country³⁰. It is important to keep in mind that rental prices in Norway are partly regulated by law. This has probably impacted the development of the relationship between house- and rental prices, and likely been contributing to the indicator being at a high level. Historically, the average P/R ratio has been 11.13³¹, but is today as high as 31.61. Moreover, incentives for owner-occupied housing are greater than rental housing, making the rental market very small³².

Nevertheless, we believe the analysis to provide valuable feedback of the current situation. Based on historical developments in the P/R ratio and house prices, the simplified analysis may in several cases be helpful to identify possible bubble tendencies.