Equilibrium Models in Real Estate Research: A Survey

Article excerpt

Journal of Real Estate Literature, 6: 1325 (1998) 1998 American Real Estate Society

PATRIC H. HENDERSHOTTFinance Department, Hagerty Hall, Ohio State University, 1775 College Road, Columbus, OH 43210

hendersh@cob.ohio-state.eduEquilibrium analysis is a valuable tool in real estate investment research. In this survey, I show how equilibrium

models have been used to estimate the required risk premium for different classes of real estate, to explain real

house prices, and to determine investment rental market adjustment and valuation (as well as to predict future

rent, price, and value developments). Equilibrium analysis has also increased our understanding of differences

in coupon or rental rates on loans or leases with and without various optionlike features. Because the work on

leases has lagged that on loans or mortgages, application of the mortgage research methodology to leases is an

especially fertile area for research.1. IntroductionThe last decade has witnessed a surge in the use of the equilibrium models of financial

economics in real estate research. The models are based on highly restrictive assumptions

and consequently yield powerful empirical implications. Nonetheless, the models appear

to be useful to understanding not only markets with easily producible products and low

transactions costs (many financial markets), where continuous equilibrium is likely a good

first approximation, but also markets for real property, where equilibrium does not continuously exist.This review features the most fundamental equilibrium conceptthat expected riskadjusted returns are equal, at least as a first approximation, across different investments.1

Topics where application of the return equivalence theorem has added significant value

include estimation of the required risk premium on different classes of real estate and

explanation of real house price appreciation. Moreover, a long-run variant of this theorem

applied to the space marketthat market rents must equal the investment user costis

useful to understanding real rental rate adjustment and thus real estate market responses

to shocks such as unexpected changes in employment growth or real interest rates. Moreover, this understanding should also prove helpful in predicting future rent and value

developments.The return equivalence theorem has also increased our understanding of the valuing and

pricing of options in alternative loan and leasing contracts.2 By pricing, I mean setting

coupons or rents on newly originated loan or lease contracts such that the loans or leases

have the same values as contracts without the option clauses earning market rates of* This is a relatively minor revision of Uses of Equilibrium Models in Real Estate Research, Journal of

Property Research, 14 (March 1997), 113. We thank the publishers for allowing publication of this version.

Earlier versions of the paper were presented at the European Real Estate Society Conference, Stockholm (June

1995), the Cutting Edge 1995 RICS Property Conference, Aberdeen (September 1995), and Auckland University. I thank David Geltner, Steven Grenadier, Austin Jaffe, Rodney Jefferies, and a referee for thoughtful

comments.Equilibrium Models in Real Estate Research: A

Survey*Abstract14 PATRIC H. HENDERSHOTTreturn. And note the lumping of loans and leases; valuation and pricing of specific loan

and lease contracts are quite analogous. This is hardly surprising given the well-known

comparability of debt and lease finance.This survey is divided into sections on property returns, real house prices, rental

adjustment and valuation, and loans and leases. For each topic, I discuss both the original

application of the return equivalence theorem and recent work in the area. Of necessity,

much research between the original application and the present is skipped over. …