Academic journal article Real Estate Economics

Market Efficiency and Return Statistics: Evidence from Real Estate and Stock Markets Using a Present-Value Approach

Academic journal article Real Estate Economics

Market Efficiency and Return Statistics: Evidence from Real Estate and Stock Markets Using a Present-Value Approach

Article excerpt

Yuming Fu [*]

Lilian K. Ng [**]

This paper develops a methodology to identify asset price response to news in the framework of the Campbell--Shiller log-linear present-value equation. We further show that a slow price adjustment in real estate markets not only induces a high serial autocorrelation in excess returns, but also dampens the return volatility and the correlation with excess returns in other asset markets. Using Hong Kong real estate and stock market data, we find that the quarterly real estate price assimilates only about half the effect of market news, whereas the quarterly stock price incorporates the news fully. Our analysis identifies a cumulative price adjustment that recovers lost information in real estate returns due to market inefficiency and thereby restores the real estate return volatility and the correlation between real estate and stock markets.

Securities markets are generally efficient in that securities prices adjust to new information instantaneously to eliminate any arbitrage opportunities (see Fama 1991). The same, however, is not observed in real estate markets. Several features of the real estate market typically prevent rapid price adjustment. Absence of short selling and the significant search time and cost required to match buyers and sellers make it very difficult for investors to act on market news immediately. Gathering timely information in the real estate markets is costly due to the decentralized nature of transactions. Moreover, these transactions are typically lumpy, and trading activities are constrained by liquidity. Homeowners generally make trading decisions jointly with their decision to move. Changes in housing prices affect homeowners' equity and thus their ability to make a down payment for a new home and to move. Thus, price discovery in residential markets can be constrained by the very price adjustment (see Stein 1995; G enesove and Mayer 1997; and Fu 1996). In nonresidential markets, obtaining financing and negotiating deals take time and, together with long-term leases, they contribute to slow price response to news. Extant empirical studies on real estate market efficiency generally focus on the predictability of excess returns by lagged own values (Case and Shiller 1989; Hosios and Pesando 1991), lagged stock market returns (Gyourko and Keim 1992), and lagged macroeconomic variables (Case and Shiller 1990). [1] Thus far, none has examined how market inefficiency may distort real estate return volatility and correlation with the stock market. The goal of this paper is to address this issue.

Corgel and deRoos (1999) summarize the extraordinary risk and return relationships found in private real estate markets. Private real estate returns have an abnormally low coefficient of variation relative to other risky assets, including real estate securities, and exhibit little correlation with stock market returns and returns on real estate securities. Such observed risk and return relationships appear difficult to reconcile and suggest an allocation to private real estate in a Markowitz model that far exceeds allocations observed in real-world investment portfolios. The abnormally low volatility of observed real estate returns is commonly attributed to appraisal smoothing problems. The private real estate returns are appraisal-based, and appraisal practices tend to bias against timely and adequate updating of real estate valuation in response to new information (e.g., see Clayton, Geltner, and Hamilton 2000; Geltner 1989; and Ross and Zisler 1991). A recent study by Lai and Wong (1998) challenges the ade quacy of this explanation and suggests that the understated volatility may be caused by real estate markets' illiquidity and high information cost. However, the link between market inefficiency and the distortion in real estate risk measures is yet to be demonstrated.

Various recovery procedures are developed to de-smooth appraisal-based returns so as to improve the measured volatility. …

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