Year Published
2006
Abstract
This paper addresses the micro-analytic foundations of illiquidity and price dynamics in the real
estate market by integrating modern portfolio theory with models describing the real estate transaction
process. Based on the notion that real estate is a heterogeneous good that is traded in decentralized markets
and that transactions in these markets are often characterized by costly searches, we argue that the most
important aspects defining real estate illiquidity in both residential and commercial markets are the time
required for sale and the uncertainty of the marketing period. These aspects provide two sources of bias in
the commonly adopted methods of real estate valuation, which are based solely on the prices of sold
properties and implicitly assume immediate execution. We demonstrate that estimated returns must be
biased upward and risks downward. These biases can be significant, especially when the marketing period
is highly uncertain relative to the holding period. We find also that real estate risk is closely related to
investors' time horizons, specifically that real estate risk decreases when the holding period increases.
These results are consistent with the conventional wisdom that real estate is more favorable to long-term
investors than to short-term investors. They also provide a theoretical foundation for the recent econometric
literature (e.g., Gatzlaff and Haurin (1997, 1998), Fisher, Gatzlaff, Geltner, and Haurin (2003), and
Goetzmann and Peng (2003)) which finds evidence of "smoothing" of real estate returns. Our findings help
explain the apparent "risk-premium puzzle" in real estate -- i.e., that ex-post returns appear too high, given
their apparent low volatility - and can lead to the formal derivation of adjustments that can define real
estate's proper role in the mixed-asset portfolio
estate market by integrating modern portfolio theory with models describing the real estate transaction
process. Based on the notion that real estate is a heterogeneous good that is traded in decentralized markets
and that transactions in these markets are often characterized by costly searches, we argue that the most
important aspects defining real estate illiquidity in both residential and commercial markets are the time
required for sale and the uncertainty of the marketing period. These aspects provide two sources of bias in
the commonly adopted methods of real estate valuation, which are based solely on the prices of sold
properties and implicitly assume immediate execution. We demonstrate that estimated returns must be
biased upward and risks downward. These biases can be significant, especially when the marketing period
is highly uncertain relative to the holding period. We find also that real estate risk is closely related to
investors' time horizons, specifically that real estate risk decreases when the holding period increases.
These results are consistent with the conventional wisdom that real estate is more favorable to long-term
investors than to short-term investors. They also provide a theoretical foundation for the recent econometric
literature (e.g., Gatzlaff and Haurin (1997, 1998), Fisher, Gatzlaff, Geltner, and Haurin (2003), and
Goetzmann and Peng (2003)) which finds evidence of "smoothing" of real estate returns. Our findings help
explain the apparent "risk-premium puzzle" in real estate -- i.e., that ex-post returns appear too high, given
their apparent low volatility - and can lead to the formal derivation of adjustments that can define real
estate's proper role in the mixed-asset portfolio
Research Category
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