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Time Variation of Liquidity in the Private Real Estate Market : Causes and Consequences

This paper evaluates competing explanations for time variation in private real estate market liquidity documented in Fisher et al. (2003). We present a search-based model of incomeproperty transactions and pricing, based on Fisher et al. (2003) and Goetzmann and Peng (2004) and use it to test three classes of models that provide alternative explanations for time variation in liquidity. In the first, seller estimates of property value lag market conditions because of an asymmetric information problem. Sellers in part base their estimates of value on observations of signals from the market, but the presence of noise means a change in signal is not fully reflected in sellers’ updated value estimates. The second class of models incorporates the option value of waiting, or opportunity cost of not transacting, recently introduced by Krainer (2001) and Nov-Marx (2004), into seller’s optimal valuation strategy. In the third, we allow for the possibility of noise traders, or investors who are not fully rational in the sense that they trade on market sentiment. We follow Baker and Stein (2003) and consider a model that links stock market-wide liquidity to investor sentiment with higher liquidity being due to the presence of irrationally over-optimistic traders. In this model measures of aggregate liquidity act as an indicator of the relative presence (or absence) of sentiment-based traders in the market place 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.”1