Constructing an index to examine house price misalignment with fundamentals in Malta

Abstract

This paper computes an aggregate misalignment index using a multiple indicator approach to identify under or over-valuation of house prices in Malta based on fundamentals. A total of 6 indicators are used that capture households, investors and system-wide factors: the house price-to-RPI ratio, the price-to-hypothetical borrowing volume ratio, price-to-construction costs ratio, price-to-rent ratio, dwelling investment-to-GDP ratio and the loan bearing capacity. These sub-indices enter the index in gap form and the weights are derived using principal component analysis. The analysis is performed using both the house price indices of the National Statistics Office (NSO) and the Central Bank of Malta (CBM), which are based on contract and advertised prices, respectively. House prices in Malta were overvalued by around 20% to 25% in the pre-crisis boom. This disequilibrium started to be corrected following the decline in house prices, with the CBM and NSO house price indices reaching a trough in 2013 and 2014, respectively. Since then, house prices started to recover although the recovery in the advertised price index was more pronounced compared to that based on contract prices. In mid-2017, advertised house prices were slightly overvalued while contract prices still have to reach their equilibrium level. The dynamics from the misalignment index, including its peaks and troughs, are remarkably similar to the range derived from statistical filters.