The New York Times reports,

Gary and Margaret Hwang Smith spend a lot of time musing about real estate…

In a paper the two presented at the Brookings Institution this week, “Bubble, Bubble, Where’s the Housing Bubble?” they said that even though prices had risen rapidly and some buyers unrealistically expected the trend to continue, “the bubble is not, in fact, a bubble in most of these areas.”

They argued that the value of a home is determined by the rent it could fetch. Calculate the future rents, subtract mortgage payments, taxes and other costs, factor in a good annual rate of return of 6 percent or more, and one should be looking at the proper price of a house or condo.

There is nothing new here. There are two ways to look at house prices.

1. Relative to historical norms, prices are very high

2. Relative to rents, prices are reasonable

Both statements are true. The first implies a bubble, and the second does not.Historical norms are for prices to be low relative to rents. That might reflect a risk premium or a liquidity premium for owning a house. In my view, there are good reasons for a liquidity premium to have shrunk over time. The mortgage market has become more efficient, so that the cost of having money tied up in a house has fallen. This story suggests to me that the rise in prices from historical norms could be rational.

Of course, that story is very similar to the story that Glassman and Hassett gave for Dow 36,000. They said that the risk premium from stocks was going away, and so the Dow was not overvalued back in 1999. Well, in retrospect, they don’t look so good, and those of us who were more inclined to see a bubble were vindicated.

For housing, I would rate the probability of a bubble at about 20 percent. My uncertainty comes from applying what I call the profitability formula:

profitability = rental rate + appreciation rate – interest cost

The appreciation rate in this case is the assumed rate of increase in rents going forward. If you think that rent is going to stay flat for the next ten years, then prices are definitely too high. If you think that rent is going to go up 5 percent per year, then prices are probably too low. I don’t think it’s an easy call.