The US Housing Market: Asset Pricing Forecasts Using

Time Varying Coefficients

HANY S. GUIRGUIS
Manhattan College, Riverdale, NY, USA
E-mail: hany.guirguis@manhattan.edu
CHRISTOS I. GIANNIKOS
Columbia Business School, Columbia University and
Baruch College, The City University of New York, NY, USA
RANDY I. ANDERSON
College of Business Administration, Florida International University, Miami, FL, USA
Abstract
The US housing market has experienced significant cyclical volatility over the last twenty-five years due to
major structural changes and economic fluctuations. In addition, the housing market is generally considered to
be weak form inefficient. Houses are relatively illiquid, exceptionally heterogeneous, and are associated with
large transactions costs. As such, past research has shown that it is possible to predict, at least partially, the time
path of housing prices. The ability to predict housing prices is important such that investors can make better
asset allocation decisions, including the pricing and underwriting of mortgages. Most of the prior studies
examining the US housing market have employed constant coefficient approaches to forecast house price
movements. However, this approach is not optimal as an examination of data reveals substantial sub-sample
parameter instability. To account for the parameter instability, we employ alternative estimation methodologies
where the estimated parameters are allowed to vary over time. The results provide strong empirical evidence in
favor of utilizing the rolling Generalized Autoregressive Conditional Heteroskedastic (GARCH) Model and the
Kalman Filter with an Autoregressive Presentation (KAR) for the parameters time variation. Lastly, we
provide out-of-sample forecasts and demonstrate the precision of our approach.
Key Words: house prices, Kalman filter, rolling GARCH, rolling VECM
1. Introduction
1.1. Overview
Both academics and practitioners are interested in understanding the dynamics of the
housing market due to its significant impact on the whole economy. In fact, the housing
sector constitutes a significant share of the GDP and it is the largest component of
household wealth in the US. Furthermore, many economists suggest that developing an
efficient housing market is a prerequisite for sustained economic development (Shiller,
1993).
1
However, modeling house price appreciation has been a challenging task for
theoreticians and econometricians due to the strong vulnerability of the housing sector to
structural changes, macroeconomic policies, regime switching, and market imperfections.
The Journal of Real Estate Finance and Economics, 30:1, 3353, 2005
#
2005 Springer Sciences + Business Media, Inc. Manufactured in The Netherlands.
While housing prices are not as volatile as many financial variables housing prices in the
USexhibit a high degree of volatility relative to many other macroeconomic variables, such
as the consumer price index and real income levels. Figure 1.a. plots house price
inflation and consumer price inflation in the US for the period 1975:01Y1998:02. The
plot reveals that house prices are much more volatile than consumer prices, with
Figure 1. The behavior of the US house prices and their determinants.
34 GUIRGUIS, GIANNIKOS AND ANDERSON
standard deviations of 0.0079 and 0.0256, respectively. Similarly, Figure 1.b. shows that
the logarithm of real house prices exhibits a stronger cyclical pattern than the logarithm of
real disposable income and consumer asset wealth.
As a result, there have been numerous theoretical and econometric studies attempting
to model and forecast these volatile house prices, many of which represent substantial
improvements in understanding pricing dynamics. In particular, the improvements
include testing for housing market efficiency, innovative specifications of the supply and
demand equations, and methodological changes in repeated sales models.
1.2. Advances in modeling the housing market
DiPasquale andWheaton(1994) modify the traditional stock-flow model by incorporating
a gradual price adjustment mechanism in their housing demand equation. On the supply
side, their independent variables include the lagged stock of housing to account for
stock equilibrium. The results support the notion of slow price adjustments and the
importance of house prices relative to the size of the housing stock. Quigley (1995)
estimates a hybrid model of housing prices from combined samples of single and
multiple sales of 843 condominiums in downtown Los Angeles during a 12-year period.
Subsequently, he models the residual variance of the hybrid model as a function of the
elapsed time between the first and subsequent sales and estimates the specific error
variance of each sale. Finally, he incorporates the error variance in the housing price
equation and re-estimates the hybrid model by GLS. He reports a significant decrease in
the standard errors and in the magnitude of the confidence intervals around the GLS-
generated housing price index.
Abraham and Hendershott (1996) calculate bubbles in the housing market as the error
term from regressing real housing prices on the growth in real construction cost, the
growth in real income per (working age) adult, the growth in employment, and the real
after-tax change in the interest rate. The authors then specify adjustment dynamics for
housing prices by expressing the bubbles as a function of the gap between equilibrium
and actual real housing prices and the lagged value of the growth rate of the real house
prices. They show that their model can explain 75% of the price changes in the West and
50% of the price changes in the Northwest during the middle and late 80s. Pain and
Westaway (1997) model house appreciation in U.K as a function of the expenditures by
consumers rather than the determinant of the expenditure. They claim that using
consumption will incorporate the permanent income measure in the housing demand
function. They report structurally stable parameters throughout the housing market
downturn that began in the early nineties.
Goetzmann and Spiegel (1997) specify the covariance matrix of repeated sales as a
function of differences in spatial proximity, education level, median income, and racial
composition. Then, they use a sample of 131,603 repeat sales in the San Francisco area to
construct ZIP code house price indexes. They find that the median household income is
the most important determinant in explaining the covariance among the housing returns.
THE US HOUSING MARKET 35
Holly and Jones (1997) adopt Johansens procedures (1988) and allow real house
prices to respond asymmetrically to innovations in real income. They find that real
income is the most important determinant in the real house price equation. In addition,
they document that real house prices adjust faster to innovations in real income when
they are above, rather than below, the long run equilibrium price suggested by the
cointegrated relationship.
Malpezzi (1999) specifies an error correction model to test whether prices converge to
some equilibrium price to income ratio. Malpezzi reports that housing prices can be
partially predicted. More specifically, he shows that there is a negative and symmetric
relationship between the changes in housing prices and deviations of the actual price-
output ratio from the long-run equilibrium relationship. Moreover, he documents the
tendency of housing prices to rise in the presence of more stringent regulations.
Crawford and Fratantoni (2003) utilize ARIMA, GARCH, and regime switching
univariate time series models to estimate the behavior of home price growth rates in
California, Florida, Massachusetts, Ohio, and Texas from 1979:01 to 2001:04. They find
that regime-switching models perform better in-sample forecasting, while ARIMA and
GARCH perform better in out-of-sample forecasting. They attribute the inferior out-of-
sample performance of the regime-switching models to the tendency of such models to
overfit the data in small samples. Finally, they conclude, BWhile regime-switching
models are useful for characterizing home price volatility patterns, we find that simpler
models might be more appropriate for point forecasts.^
Hall et al., (1997) estimate real house prices in UK by employing an error correction
model in which the parameters are allowed to vary according to a two-state Markov-
switching mechanism. The results of their paper confirm the parameters instability due
to the economic fluctuations and the size of the deviation from the long-run equilibrium.
Brown et al., (1997) employ the Kalman filter with time varying parameters, the error
correction and the vector autoregressive models with constant parameters to estimate real
house prices in the UK. The authors allow the Kalman coefficients of the nominal user
cost and of the expected gains on housing to follow a random walk with income and
mortgage interest rate as the driving forces over time. They show that the forecasting
performance of Kalman filter with time varying parameters outperform those of the error
correction and the vector autoregressive models with constant parameters.
There have also been some studies that have used Kalman filters with house price data
such as Clapp and Giaccotto (2002), Giaccotto and Clapp (1992) and Francke and de Vos
(2000). Clapp and Giaccotto (2002) use an autoregressive process to model the time
series behavior of a city-wide house price index. They then produce one-quarter ahead
forecasts for individual properties. This framework is then fitted with housing
transactions from Dade County, Florida. Prediction errors for two forecasting models
(hedonic and repeat sales) show some departures from desirable properties of any such
forecast. Both models exhibit informational inefficiency but the hedonic appears to be
less inefficient. Giaccotto and Clapp (1992) use Monte Carlo simulation to study the
statistical properties of real estate returns. They construct a model where transaction
prices are noisy signals of true prices. A number of rules then are considered to estimate
the true price and rate of return. Exponential smoothing and Kalman filter rules are shown to
36 GUIRGUIS, GIANNIKOS AND ANDERSON
perform well. Francke and de Vos (2000) present a model for stochastic hierarchical
trends. The trends are analyzed on two levels, on a general and on a cluster level. The
model is developed for a large database containing selling prices of houses in different
neighborhoods and is operational in Amsterdam for the determination of real-estate taxes.
While the recent studies indicated above have shown the value of using time-varying
approaches to forecast housing prices, there are only a very limited number of studies of
the US housing market that take a similar approach and they do not work within the same
asset market framework that we consider. Hence, the purpose of this paper is to first
examine the stability of the parameters to determine if a time varying technique is
appropriate and necessary, and secondly, if it is, to account for the structural instabilities
in the real house prices by applying different time varying coefficient techniques
following an asset market approach. Additionally, we investigate whether the volatility in
the housing market can be capture by time-varying bivariate GARCH models.
In line with DiPasquale and Wheaton (1994), Mankiw and Weil (1989), Peek and
Wilcox (1991), Albert (1962), Brady (1967), Maisel (1963), Huang (1966), and Muth
(1960), we use aggregate data to examine changes in the U.S housing market associated
with the macroeconomic structural changes. We adopt six different estimation techniques
in which the estimated parameters are allowed to vary over time:
1. The rolling vector error correction model (VECM),
2. The rolling autoregressive representation (AR)
3. The rolling generalized autoregressive conditional heteroskedastic (GARCH)
model,
4. The Kalman filter with a random walk (KRW) and
5. The Kalman filter with an autoregressive presentation for the parameters time
variation (KAR),
6. Exponential smoothing with trend and seasonality (ES)
The out-of-sample forecasting performance of the six estimation techniques is then
evaluated over an intensive time period extending from 1985:03 to 1998:02. The results
document the volatility of the house prices in the US and the out-performance of the
forecasts generated by the rolling GARCH and KAR techniques.
The remainder of this paper is organized as follows: Section 2 derives the theoretical
model of housing prices, Section 3 examines the time series properties of the data,
Section 4 addresses the instability of the parameters, Section 5 explains the estimation
techniques adopted in the paper, Section 6 presents the empirical results, and Section 7
summarizes and concludes the study.
2. The house price model
The theoretical model presented in this paper is based on the asset market approach
introduced by Buckley and Ermisch (1982), Poterba (1984), Meen (1990, 1996), and
Breedon and Joyce (1993). In the spirit of the asset market approach, the problem facing
THE US HOUSING MARKET 37
the consumer is to maximize lifetime utility U. With a real discount rate r, in continuous
time, the lifetime utility is an integral of the discounted period utilities which are a
function of housing services approximated by the stock of houses H(t), and the
consumption of composite non-durable goods C(t). Thus, the constrained optimization
problem is to maximize the utility function
U
_
1
0
e
rt
u H t . C t dt 1
subject to:
the households budget constraint
RHP t X t S t C t 1 0 RY t 1 0 iA t . 2
and the following two technical constraints describing the evolution of the housing stock
H(t) and the real net non-housing assets A(t)
H
0
t X t 0H t . and 3
A
0
t S t PA t
4
where RHP(t) is the real purchase price of housing, S(t) is real saving net of real new
loans, RY(t) is the real household income, i is the nominal mortgage interest rate, 0 is the
marginal household tax rate, P is the constant inflation rate, is the physical depreciation
rate on the housing stock, while X(t) represents new purchases of dwellings. (
0
) is the
time derivative. The first order solution of the Lagrangian function can be stated as
follows,
U
h
Uc
RHP t 1 0 i P0
RHP
0
t
RHP t
_ _ _ _
5
As in Bowden (1980), equation (5) can be written in terms of the unobservable market
clearing real rental price of housing services R(t) as follows:
RHP t
R t
1 0 i P
e
0
RHP
e
0
RHP t
_ _ _ _ 6
or equivalently
RHP t
R t
NMR T PHE t 0
7
where PHE t P
e

RHP
e
0
RHP t
_ _
38 GUIRGUIS, GIANNIKOS AND ANDERSON
Now (7) can be rewritten as,
ln RHP t ln R t ln NMR t PHE t c 8
As such, the unobservable real rental price of housing service R(t) can be represented by
its observable determinants (Meen (1990)),
R t F RY t . POP t . HS t . W t 9
where HS(t) is the stock of owner occupied dwellings, RY(t) is real disposable income,
POP(t) is the fraction of the population aged between 25 and 35, and W(t) is the consumers
asset wealth. Finally, equations (8) and (9) suggest the following empirical house price
equation,
RHP t f RY t . NMR t . PHE t . POP t . HS t . W t 10
Here, we have utilized the unrestricted form of the real interest rate by allowing real
house prices to respond asymmetrically to the NMR and PHE.
2
3. Data description and analysis
3.1. Overview
The data used in this paper consists of quarterly observations of real house prices (RHP),
real disposable income (RY ), the population ratio (POP), owner occupancy (HS ), the
expected nominal capital gains (PHE), the nominal post-tax mortgage interest rate
(NMR) for the sample period extending from 1975:01 to 1998:02. As in Meen (1990), the
expected nominal capital gains (PHE) are calculated as the actual change in nominal
house prices over the past year, expressed as an annual rate.
3
3.2. Graphical depiction of house prices and the independent variables
The behavior of the logarithm of real house prices is plotted in Figure 1.c. and d. against
the nominal post-tax mortgage interest rate, and the logarithm of the expected nominal
capital gains, respectively. Figure 1.c. shows that the rapidly rising mortgage rates during
the late seventies and early eighties reduced the affordability of owner-occupied housing,
and thus reduced the demand for housing and the real prices as well. Figure 1.c. also
reveals the negative relationship between real housing prices and the nominal post-tax
mortgage rate, except during the late eighties and early nineties when consumer spending
was weak due to a substantial decline in real income. Figure 1.d. shows a strong positive
relationship between real house prices and nominal capital gains due to the fact that the
accrued capital gains are current additions to household resources.
Figure 1.e. and f. depict the logarithm of real house prices against the population ratio
(POP), and the logarithm of owner occupancy (LHS ). The rationale for including POP
THE US HOUSING MARKET 39
and LHS as proxies for the unobservable equilibrium real rental price of housing service
stems from the fact that both variables affect the demand for housing and hence the
affordability of housing. Figure 1.e. shows the sharp rise in the population ratio during
the eighties as a result of the baby boomers being in the 25 to 35 year old age bracket. As
revealed by the figure, this era was characterized by a significant increase in the demand
for housing; and thus, the highest level of housing prices. The figure also reveals the
subsequent decline in the population ratio and housing prices during the nineties due to
the low number of births in the seventies (the baby bust). Finally, Figure 1.f. reveals the
continuous rise in the residential stock of housing in the US, as measured by LHS during
the last twenty-five years.
3.3. The house price equation
We start our analysis by conducting the Phillips-Perron unit root tests on the level and
the first difference of each variable in the real house price equation for the whole sample
period extending from 1975:01 to 1998:02. The non-stationarity of the variables is
accounted for by taking the first difference. Table 1 displays the results of unit root tests
for each variable where the appropriate number of lagged differences is determined by
the BIC criterion.
The results reveal, at the 1% level of significance, that LRHP, LRY, LHS, NMR, PHE,
POP, and W have one unit root. Next, we test for the independent cointegrating vectors
among the non-stationary variables for the whole sample period. The analysis is
conducted using the trace and maximal eigenvalue tests among LRHP, LRY, NMR, PHE,
POP, LHS, and LW. Table 1 suggests that there are two independent cointegrating
vectors based on the trace test and one cointegrating vector based on the maximal
eignvalue test at the 1% significance level. We decide to choose the more parsimonious
specification by including only one cointegrating vector in our empirical analysis. As
suggested by the economic theory, the signs of the variables in the cointegrating vector
are positive for LRY, PHE, POP, and LW and negative for NMR, and LHS. Although a
number of variables are considered in forming the cointegrated vector, the only
independent variables in the real housing price growth rate equation are: the first
differences of real disposable income, the nominal post-tax mortgage rate, the expected
nominal capital gains, the population ratio and the cointegrated vector. LHS and LRY
have not been statistically significant in any of the statistical tests reported in the
following sections.
4
Thus, our data analysis suggests the following housing price
equation:
DLRHPt F
_
DLRHPt 1. DLW t . DNMR t .
DPHE t . DPOP t . COIN t 1

11
where BD^ and COIN refer to the first difference of each variable and the cointegrating
vector, respectively.
40 GUIRGUIS, GIANNIKOS AND ANDERSON
Table 1. Unit root tests and cointegration analysis (75:01Y98:02).
Unit root tests
Variable Phillips-Perron (Lags)
LRHP j1.55 (4)
DLRHP j4.63* (4)
LW j0.25 (0)
DLW j8.33* (0)
NMR j0.58 (1)
DNMR j6.41* (1)
PHE j2.68 (0)
DPHE j10.74* (0)
LHS j1.46 (1)
DLHS j4.14* (1)
POP j0.63 (4)
DPOP j10.1* (4)
Cointegration analysis
Endogenous series:
LRHP LW NMR PHE POP LHS
L-max Trace H0: r H1:p-r L-max99 Trace99
72.80 158.07 0 6 45.10 103.18
32.07 85.27 1 5 38.77 76.07
30.00 53.19 2 4 32.52 54.46
15.73 23.19 3 3 25.52 35.65
7.18 7.45 4 2 18.63 20.04
0.27 0.27 5 1 6.65 6.65
Cointegration vectors based on one long-run relationships
Variables Vector (1) Normalized vector (1)
LRHP j11.198 j1.000
LW 10.753 0.960
NMR j0.314 j0.028
PHE 29.300 2.616
POP 99.318 8.869
LHS j2.189 j0.195
Notes: a) A constant and a time trend are included in the Dickey-Fuller and Phillips-Perrson tests. b) The *
indicates significance at the 99% level. c) The appropriate number of lagged differences is determined by the
BIC criterion. d) BD^ refers to the first difference of each variable.
THE US HOUSING MARKET 41
Figure 2. Estimated coefficients of real house prices (DLRHP) by OLS.
42 GUIRGUIS, GIANNIKOS AND ANDERSON
4. Sub-sample instability
After defining our house price appreciation equation, we need to examine the stability of
the parameters. To begin with, recall from Figure 1, the high volatility of housing prices
relative to the other macroeconomics variables. To formally test whether such a high
degree of volatility implies that the coefficients in the housing price equation are
unstable, we employ three statistical tests.
First, we estimate the real housing price equation by running a battery of rolling OLS
regressions. The first regression runs from 1975:1 to 1985:01. Then we roll the sample
Figure 2. Continued.
THE US HOUSING MARKET 43
forward from 1985:02 to 1997:02. As shown by Figure 2.a. the coefficients indicate a high
degree of instability and do not converge to a constant value as the sample size increases.
Next, we run a sequence of Chow tests for the sample period from 1975:1 to 1997:2
using the following equation:
DLRHP
t
u
1
u
2
DLRHP
t1
u
3
DLW
t
u
4
DNMR
t
u
5
DLPHE
t
u
6
DPOP1
t
u
7
COIN1
t1
u
8
T
i
DLRHP
t1
u
9
T
i
DLW
t

u
10
T
i
DNMR
t
u
11
T
i
DLPHE
t
u
12
T
i
DPOP
t

u
13
T
i
COIN1
t1
u
14
T
i
u
t
12
where T
i
is a dummy variable such that
T
i
t 0 for t < i. and
T
i
1 for t i
and i 1979 : 02. . . . . 1995 : 03.
The null hypothesis is that the us are the same for t < i and t Q i. We run a different test
for each T
i
and test for the null hypothesis of parameter stability by restricting u
8
, u
9
,
u
10
, u
11
, u
12
, u
13
, and u
14
to equal zero, where the test statistics follow a @
2
distribution
with three degrees of freedom.
Finally, we employ RESET tests for the sample period starting at 1975:01 and rolled
forward from 1985:01 to 1997:02 using the following equation:
DLRHP
t
u
1
u
2
DLRHP
t1
u
3
DLW
t
u
4
DNMR
t
u
5
DLPHE
t
u
6
DPOP1
t
u
7
COIN1
t1
u
8
DLRHP
t1

2
u
9
DLRHP
t1

3
u
10
DLRHP
t1

4
u
t
13
In this case, the null hypothesis is that there is no incorrect functional form that might be
generatedbynot allowingthe parameters tovaryover time. We test for the null hypothesis by
restricting u
8
, u
9
, and u
10
to equal zero, where the test statistics follow an F-distribution.
The tests for the parameters stability are reported in Figure 2.b. The Chow and RESET
tests reject the null hypothesis of parameter stability for most of the sub-periods.
The statistical results confirm the coefficient instability in the price equation that might
result from structural changes, behavioral adjustment (Lucas critique), measurement
errors and incorrect functional forms. As pointed out by Engle and Watson (1987), and
Brown et al., (1997), time varying coefficient models are the recommended techniques to
adopt in such a volatile environment. In the next section, we introduce the five time-
varying coefficient techniques adopted in our paper.
44 GUIRGUIS, GIANNIKOS AND ANDERSON
5. Estimation techniques
5.1. Rolling vector error correction model (VECM)
To correct for the non-stationarity of the data, we include the stationary presentation of
the variables in the VARs where all the variables are I(0). We also include the error
correction term calculated from the whole sample period extending from 1975:01 to
1997:2. The importance of including the error correction terms in the VARs is pointed
out by Engle and Granger (1987, p.259).
5
We then run all the regressions with 1 to 6 lags
(K) for each variable. In summary, the empirical vector error correction model used to
examine the housing price can be stated as follows:
X
t
Cons tan t A L X
t
COIN
t1
e
t
14
where X
t
= (DLRHP
t
, DLW
t
, DNMR
t
, DPHE
t
, DPOP
t
) and L is the first lag operator
A(L) = c
1
L + c
1
L
2
+ . . . + c
1
L
k
.
5.2. The rolling autoregressive presentation (AR), and the generalized autoregressive
conditional heteroskedastic (GARCH) model
Here, we investigate whether housing price volatility can be modeled to capture the time
variations in the housing market. To account for such volatility, we model real housing
prices as a generalized autoregressive conditional heteroskedasticity (GARCH) process.
We start our analysis by searching for the most parsimonious AR specification of the real
house prices in the US. However, the ACF and PACF of the real house prices suggest
different lags depending on the sample periods. Thus, we try different lag specifications
from AR(1) to AR(6), and choose the AR(6) with the best forecasting performance.
Although the AR(6) models appear adequate, the high volatility of the real house
prices, as indicated by Lagrange multiplier and the Ljung-Box Q-statistics of the
squared residual during the late seventies and eighties, suggests some changes in the
variance that can be hypothesized by the ARCH, ARCH-M, or GARCH model. Again,
we try different specifications and reach the final preferred model specified by
GARCH(1,1) with AR(6).
6
5.3. A time varying kalman filtering with a random walk (KRW) and an
autoregressive (KAR) presentation
In our next tests, we employ the time varying Kalman Filter technique introduced by
Doan et al.,(1984) to estimate housing prices in the US. The time-variation of the
coefficients is allowed to follow random walk (KRW) and autoregressive specifications
THE US HOUSING MARKET 45
(KAR) where the coefficient vector shrinks toward the mean. The time varying Kalman
filtering model can be specified as follows:
The Measurement Equation:
DLRHP
t
u
1
u
2
DLRHP
t1
u
3
DLW
t
u
4
DNMR u
5
DPHE
t
u
6
DPOP
t
u
7
COIN1
t
u
t
15
The State Equation:
RandomWalk Specification : u
i.t
u
i.t1
V
t
Autoregressive Specification : u
i.t

1
u
i.t1
1
1
u
mean
V
t
16
with VAR(V
t
) = M
t
and
1
is the shrinking factor toward the coefficient mean u
mean
,
where u
mean
= [0 1 0 0 0 0 0]
0
.
To initialize the state vector and the covariance matrices, we use the mean and the
covariance matrix of the unconditional distribution of us, and calculate the hyper-
parameters (relative tightness and shrinkage factors) from the maximized log conditional
likelihood function over the sample period 1975:01 to 1998:02.
7
We use the estimsated
hyper-parameters and the initialized state vector and covariance matrices to estimate the
model for the period 1975:01 to 1985:02. Then, we execute the Kalman filter for the
periods 1985:02 to 1997:04.
5.4. An exponential smoothing with trend and seasonality (ES) presentation
In our final tests, we employ the exponential smoothing methodology where the best
fitting model (based on Schwartz criterion) for the different time periods is a model with
additive seasonality and no trend. In addition, we estimate the smoothing parameters for
each period by choosing the parameters which minimize the in sample squared one-step
forecast errors.
6. Empirical results
Figures 3 and 4 show the time varying coefficients of the KAR, KRW, AR, and GARCH
8
as the sample is rolled forward from 1985:02 to 1997:04; the date on the horizontal axis
indicates the end date of the samples. For example, the coefficients for the sample period
extending from 1975:01 to 1982:02 are presented by the 1982:02 on the horizontal axis.
The coefficients reveal a high degree of instability in the housing market and confirm the
results from Chow tests, particularly during 1991Y1992.
46 GUIRGUIS, GIANNIKOS AND ANDERSON
Table 2 reports the MFE, MAFE, RMSFE, and the Theil Ustatistics at one to four quarter
horizons. The results reveal that the forecasts of the KAR and the rolling GARCH
outperform the forecasts of the other estimation techniques for the whole time period
expanding from 1985:2 to 1998:02 for the four forecasting horizons. The statistics also
reveal that the MFE of the rolling GARCH are smaller and have the tendency to change
Figure 3. Estimated coefficients of real house prices by GARCH(1,1) and AR(6).
THE US HOUSING MARKET 47
signs over the forecasting periods. For example, the average MFE for the four step forecasts
by GARCH forecasts are j0.000006, whereas the average errors by KAR, KRW, AR,
VECM, and ES are 0.00024, 0.00356, j0.004, 0.00099, and j0.000161 respectively.
Finally, Figure 5 shows the forecasts of KARand GARCHas compared to actual real house
price appreciation at horizons of one, two, three, and four quarters.
9
For example, the one-
Figure 4. Estimated coefficients of real house prices by KAR, and KRW.
48 GUIRGUIS, GIANNIKOS AND ANDERSON
Table 2. Comparison of rolling VECM, AR, KRW, KAR, SMOOTH out-of-sample forecasts.
Measure Model 1-step 2-step 3-step 4-step Average
MFE
VECM (5) 0.00130 0.00121 0.00104 0.00131 0.00123
AR (6) j0.00432 j0.00454 j0.00474 j0.00468 j0.00457
GARCH (1, 1) 0.00011 0.00001 j0.00024 j0.00131 0.00006
Kalman (KRW) 0.00191 0.00186 0.00190 0.00187 0.00189
Kalman (KAR) 0.00140 0.00119 0.00112 0.00111 0.00121
ES 0.00014 0.00008 j0.00026 j0.00061 j0.00016
MAFE
VECM (5) 0.00823 0.00801 0.00796 0.00750 0.00795
AR (6) 0.00801 0.00798 0.00820 0.00836 0.00814
GARCH (1,1) 0.00676 0.00654 0.00674 0.00651 0.00664
Kalman (KRW) 0.00596 0.00586 0.00582 0.00582 0.00587
Kalman (KAR) 0.00599 0.00576 0.00584 0.00573 0.00583
ES 0.00860 0.00981 0.01270 0.01260 0.01095
RMSFE
VECM (5) 0.01040 0.01150 0.00101 0.01050 0.01061
R (6) 0.00941 0.00935 0.00956 0.00954 0.00947
GARCH (1,1) 0.00777 0.00752 0.00779 0.00752 0.00766
Kalman (KRW) 0.00731 0.00721 0.00720 0.00718 0.00723
Kalman (KAR) 0.00702 0.00678 0.00681 0.00676 0.00685
ES 0.01040 0.01180 0.01540 0.01510 0.01318
U THEIL
VECM (5) 0.32369 0.35960 0.33577 0.36346 0.34563
AR (6) 0.30181 0.31111 0.32443 0.34129 0.31966
GARCH (1,1) 0.26590 0.26479 0.27588 0.28117 0.27194
Kalman (KRW) 0.24722 0.25004 0.25430 0.26653 0.25452
Kalman (KAR) 0.23593 0.23298 0.23730 0.24754 0.23844
ES 0.33629 0.39351 0.48727 0.51410 0.43279
MFE

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THE US HOUSING MARKET 49
quarter forecast for 1990:01 is calculated from the sample period extending from 1975:01
to 1989:04, and the two-quarter forecast for 1990:01 is calculated from the sample period
extending from 1975:01 to 1989:03. Figure 5 reveals the high accuracy of our forecasts,
which capture the main movements in real house prices between 1982:03 and 1998:02.
Figure 5. Rolling forecasting by GARCH and KAR.
50 GUIRGUIS, GIANNIKOS AND ANDERSON
7. Summary and conclusions
Although there have been numerous theoretical and empirical studies of the housing
market and house price appreciation in the US, the literature has not accounted for the
sub-sample instability of housing prices. This paper documents the volatility and cyclical
fluctuations in house price appreciation. As such, our findings cast concerns on the
results of the prior studies that use constant coefficient approaches. To account for such
instability, we utilize, examine, and test a variety of empirical models in which the
estimated coefficients are allowed to vary as the sample extends from 1985:02 to
1997:02. The comparison of the out-of-sample forecasts indicates that the forecasts
generated by the Kalman Filter, with an autoregressive presentation for the parameters
time variation and the rolling GARCH techniques outperform the forecasts of all the
other specifications considered. Moreover, our out-of-sample forecasts exhibit a high
degree of accuracy at the one to four quarter horizons.
Acknowledgments
We are especially grateful to William N. Goetzmann for generously providing advice and
to two anonymous reviewers of the JREFE and the editor, James Kau, who helped us
with their comments to significantly improve the paper. We also wish to thank Walter
Enders, Edward Rogoff, Perry-Lynn Moffitt, and Sonchawan Tamkaew for their
comments. Naturally, we retain responsibility for any remaining errors. The second
author gratefully acknowledges research support from the Research Foundation of
CUNY and Columbia Business School.
Appendix: The data
P Consumer price index at 82Y84 prices from CITIBASE (Punew).
HP Nominal house price from Federal Housing Finance Board (National Survey of
House Prices MIRS).
RHP Real House Price = (HP/P) * 100.
DLRHP Growth rate of Real House Price = LOG(RHP
t
) j LOG(RHP
tj1
).
DLNHP Growth rate of Nominal House Price = House price inflation = LOG(HP
t
) j LOG(HP
tj1
)
PHE Expected nominal capital gains on housing is calculated as the actual change in nominal house
prices over the past year expressed as an annual rate.
PHE = DLNHP
tj1
+ DLNHP
tj2
+ DLNHP
tj3
+ DLNHP
tj4
.
GMPY Total personal income in Billions from CITIBASE.
T Personal Taxes Proceeds in Billions from CITIBASE (GMPTX).
TY Income Tax Rate = (T/GMPY) * 100.
Y Disposable household income from CITIBASE (GMYD).
RY Real disposable household income = [(Y)/P] * 100.
DLRY Growth rate of RY = log(RY
t
) j log(RY
tj1
).
MR Mortgage Rate from Federal Housing Finance Board (National Survey of House Prices MIRS).
THE US HOUSING MARKET 51
Notes
1. The recent article by Clapp and Giaccotto (2002) provides a review of the literature that summarizes the
studies on the housing market efficiency. Their synthesis suggests that the US housing markets is certainly
weak form inefficient and many studies suggest that the housing market is also inefficient in the semi-strong
form.
2. For more details see Meen (1990), page 12.
3. For more details about the data series and their sources see the Appendix.
4. The correlation coefficient between asset wealth and real disposable income is 0.82. In choosing between
LW and LRY, the LW exhibits stronger explanatory power and better overall forecasting performance.
5. Engle and Granger (1987) state: BThus vector autoregressions estimated with cointegrated data will be mis-
specified if the data are differenced, and will have omitted important constraints if the data are used in
levels. Of course, these constraints will be satisfied asymptotically but efficiency gains and improved
multistep forecasts may be achieved by imposing them.^
6. The results are available upon request.
7. The estimated hyper-parameters of the Kaman filter (AR) are as follows: 2 = Relative tightness on other
variables = 0.25, 3 = Relative tightness on the constant. = 10000, 5 = Overall tightness = 0.04, 7 =
Relative tightness on time variation = 0.00000001, and 8 = Shrinkage factor toward mean = 0.97. For more
details see Doan et al.,(1984) page 10, and the RATS manual.
8. We did not report the estimated parameters from the VECM(5), and the exponential smoothing (ES) to save
space. The results are available upon request.
9. We did not report the out-of-sample forecasts from the AR(6), VECM(5), Kalman (KRW), and the
exponential smoothing (ES) to save space. The results are available upon request.
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