REAL ESTATE PRICING

Real Estate Pricing

Real Estate Pricing

Introduction

The real estate investment decision is not just ''to buy, or not to buy”. It is as much ''when to sell”. In fact, the two decisions are inherently interdependent, since the timing of the sale, which provides the single largest cash flow, critically affects the expected overall return of the investment. In the current practice, however, the issue of holding period for a real estate investment is basically a matter of arbitrary assumption. For example, a typical Discounted Cash Flow (DCF) analysis for commercial property valuation usually assumes a holding period of 10 years.

Sustained imbalances in real estate markets can jeopardize the soundness of the financial sector, due to banks' central role as mortgage lenders and the frequent use of real estate as collateral (Goodhart and Hofmann, 2007). Corrections of real estate prices have preceded financial crises in the past, so policymakers often assess financial sector vulnerability on the basis of property prices, among other indicators (IMF, 2003).1 We address the questions of whether and how deviations from fundamentals in the real estate sector transmit to the (in)stability of banks.

Inherently frequent and persistent deviations from fundamental values in real estate markets are central to the real estate-financial fragility nexus. In a frictionless world, property (just like any other asset) is priced by discounting expected cash flows, which in this case depend on demand and supply for real estate. The latter depend on macroeconomic fundamentals, such as population growth, real income, or wealth. House prices then should reflect economic cycles (e.g., Herring and Wachter, 1999; Higgins and Osler 1999; Collyns and Senhadji, 2002; Leamer, 2007) But this relationship is likely to be muted for three main reasons. First, real estate involves nonstandardized assets that differ in quality and are (regionally) segmented. Second, the absence of central trading places implies imperfect information and price negotiations that both lack transparency and involve high transaction costs. Third, supply responses in the housing market are sluggish due to construction lags and limited land availability (McCarthy and Peach, 2004). As a result, sustained deviations from long-run equilibria are more likely in the housing market, relative to financial markets (Herring and Wachter, 1999).

Literature Review

Theoretical studies assign the banking sector a crucial role in fueling such deviations. The so-called financial accelerator mechanism consists of two offsetting effects of house prices on bank stability (Kiyotaki and Moore, 1997). Increasing house prices boost bank capital by increasing the value of the real estate owned by the bank and the value of any collateral pledged by borrowers. In particular, real estate price appreciation discourages sub-prime mortgage borrowers from defaulting (Daglish, 2009). Thus, increasing real estate prices should reduce the riskiness of banks' assets and decrease the likelihood of financial distress in the banking sector (Niinimaki, 2009). This collateral value hypothesis suggests that increasing real estate prices enhance bank stability and predicts a negative relation between nominal house price changes and the bank's probability of default (PD).

This paper tests these two competing hypotheses empirically using ...