Illiquidity and Pricing Biases in the Real Estate Market

This paper addresses the micro-analytic foundations of illiquidity and price dynamics in the realestate market by integrating modern portfolio theory with models describing the real estate transactionprocess. Based on the notion that real estate is a heterogeneous good that is traded in decentralized marketsand that transactions in these markets are often characterized by costly searches, we argue that the mostimportant aspects defining real estate illiquidity in both residential and commercial markets are the timerequired for sale and the uncertainty of the marketing period. These aspects provide two sources of bias inthe commonly adopted methods of real estate valuation, which are based solely on the prices of soldproperties and implicitly assume immediate execution. We demonstrate that estimated returns must bebiased upward and risks downward. These biases can be significant, especially when the marketing periodis highly uncertain relative to the holding period. We find also that real estate risk is closely related to investors' time horizons, specifically that real estate risk decreases when the holding period increases.These results are consistent with the conventional wisdom that real estate is more favorable to long-terminvestors than to short-term investors. They also provide a theoretical foundation for the recent econometricliterature (e.g., Gatzlaff and Haurin (1997, 1998), Fisher, Gatzlaff, Geltner, and Haurin (2003), andGoetzmann and Peng (2003)) which finds evidence of "smoothing" of real estate returns. Our findings helpexplain the apparent "risk-premium puzzle" in real estate -- i.e., that ex-post returns appear too high, giventheir apparent low volatility - and can lead to the formal derivation of adjustments that can define realestate's proper role in the mixed-asset portfolio