Over the past three years house prices have risen rapidly. Between December 2007 and August 2010 prices rose by 35 percent in real terms – an average annual rise of 12 percent, much faster than their long term rate of increase. Against this background, concerns have been raised that prices have become disconnected from market fundamentals and that the recent rise has been driven by expectations of capital gains, which suggests the development of a bubble in house prices in this period. The objective of this paper is to evaluate whether a bubble has developed in house prices. To that end, we first review the course of prices over the last few decades and their development relative to rents and income; we then use standard asset-pricing methodology for estimating the "fundamental price" through three different approaches. Our analysis suggests that while prices are somewhat high relative to market fundamentals, from a long-term perspective their level is not exceptional relative to past episodes of rising house prices. According to our estimates, current prices (as of August 2010) are between 3 percent below and 10 percent above the fundamental price. That is, we do not find evidence supporting the existence of a bubble in house prices. If a bubble exists, it is in its early phases and it is still hard to detect from the data.

* This research was presented in the Bank of Israel Research Department conference on "The Capital and Housing Markets" in December 2010.

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