Real Estate

Brunnermeier, Markus K, and Christian Julliard. “Money Illusion and Housing Frenzies”. The Review of Financial Studies 21 (2008): , 21, 135-180. Print.Abstract

A reduction in inflation can fuel run-ups in housing prices if people suffer from money illusion. For example, investors who decide whether to rent or buy a house by simply comparing monthly rent and mortgage payments do not take into account the fact that inflation lowers future real mortgage costs. We decompose the price-rent ratio into a rational component-meant to capture the "proxy effect" and risk premia–and an implied mispricing. We find that inflation and nominal interest rates explain a large share of the time series variation of the mispricing, and that the tilt effect is very unlikely to rationalize this finding.

money_illusion_housing_frenzies.pdf slides.pdf

The confusion between changes in nominal and real interest rates boosts real house prices when inflation declines.