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

This paper characterizes the behavior of and evaluates competing explanations for time variation in private real estate market liquidity documented in Fisher et al. (2003). In the first, sellers 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 incorporates the option value of waiting, or opportunity cost of not transacting, recently introduced by Krainer (2001) and Novy-Marx (2004), 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 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.