Academic journal article The Journal of Real Estate Research

Time Variation of Liquidity in the Private Real Estate Market: An Empirical Investigation

Academic journal article The Journal of Real Estate Research

Time Variation of Liquidity in the Private Real Estate Market: An Empirical Investigation

Article excerpt


This paper characterizes the behavior of and evaluates competing explanations for time variation in private real estate market liquidity. In the first, sellers base their estimates of value on observations of signals from the market. The second incorporates the option value of waiting or the opportunity cost of not transacting into seller's optimal valuation strategy. In the third, we allow for the possibility of investors who are not fully rational in the sense that they trade on market sentiment and we link market-wide liquidity to investor sentiment. In this model, measures of aggregate liquidity act as an indicator of the relative presence (or absence) of sentiment-based traders in the market and therefore the divergence of asset price from fundamental value. Empirical findings are generally consistent with models of optimal valuation with rational updating and provide support for the opportunity cost approach.

"The most important and perhaps obvious lesson from the recent market cycle, however, is the potentially awesome power of capital flows in the real estate industry. Ironically, the same could be said of the downturn in the early 1990s. Then, however, it was a lack of capital and liquidity that exacerbated the weak conditions in the physical space markets rather than the excess liquidity that has created distortions today."

Charles Lowry, CEO, Prudential Real Estate Investors, 2004

Private real estate markets are characterized by a relative lack of liquidity, and the degree of liquidity can vary considerably over time. Strong (or "hot") markets with rising prices are characterized by both an increase in sales activity and a decrease in the average time-on-the-market required to sell a property. Conversely, falling (or "cold") markets typically exhibit a decrease in sales and a concomitant increase in average time-on-the-market. The relationship between market activity, liquidity, and prices has puzzled economists because it appears that property markets violate a fundamental tenet of economics; that prices adjust to equilibrate supply and demand. It seems that prices do not rise "enough" in up markets (resulting in increased sales) and do not fall "enough" and are downwardly rigid, in down markets (resulting in a decrease in sales).

While widely understood as important, it is only recently that researchers have begun to formally model and empirically examine the dynamics of liquidity changes over time and the resulting effects on commercial property prices. Fisher, Gatzlaff, Geltner, and Haurin (2003), hereafter FGGH (2003), present a searchtheoretic model of property transactions and pricing that explicitly recognizes that observed transaction prices are conditional on overall market liquidity at the time of sale (i.e., price and liquidity are jointly determined). They define a "constant liquidity value" of a property, as the value assuming no change in the level of market transaction activity, and derive a constant liquidity version of the National Council of Real Estate Investment Fiduciaries (NCREIF) property value index. The difference between this and a hedonic value index, based on observed transaction prices that implicitly reflect time variation in liquidity, provides a calibration of commercial property liquidity. Exhibit Ia plots both the constant liquidity and hedonic versions derived from NCREIF transaction data. As one might expect, the two series move closely together overall with the constant liquidity index displaying wider swings over time. The differences are particularly pronounced in market upswings and downturns. Relative to the transaction-based index, the constant liquidity index falls further in the major downturn of the early 1990s and rises more in the late 1990s market upswing; clearly liquidity has a large impact on reported transaction prices in these two periods.1

Goetzmann and Peng (2006) show that transaction prices in markets for heterogeneous goods provide misleading measures of both the market demand and market supply when buyers and sellers have different valuations (i. …

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