Fundamentals and rational bubbles in the Korean housing market: A modified present-value approach

This paper employs the present-value approach to examine the dynamics of the Korean housing market. To capture the large swing in the price-rent ratio accompanied by intermittent ups and downs, we incorporate a periodically collapsing bubble in an otherwise standard present value model. We then decompose the movements in the actual price-rent ratio into those explained by the expectations of housing market fundamentals (i.e., the rent growth, risk-free interest rate, and excess returns from housing investment) and the bubble. The bubble part set aside, most of the variations in the price-rent ratio are explained by the expected risk premium of housing investment, whereas the expected real interest rate and rent growth account for relatively small fractions of the variations. It is also found that the bubble has continuously accumulated since the early 2000s, reaching as high as 51% of the house price around the end of 2014. Finally, the recent increases in house price over 2007–2014 are likely to have been driven by self-fulfilling expectations typical of a bubble. •We construct a modified present value model to investigate the role of fundamentals and speculation in the Korean housing market since the late 80s.•We append the standard present value model with a speculative bubble which gestate and collapse periodically.•The fundamental part of the price-rent ratio turns out to be mostly driven by the expected future risk premium for housing investment, not by the expected flow of rent income or the risk-free rate of return.•Having increased steadily since the early 2000s, the bubble part takes as large as 51% of the actual house price as of 2014:Q3.•The recent increases in house price over 2007-2014 are likely to have been driven by self-fulfilling expectations typical of a bubble.