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Real Estate Returns and Risk with Heterogeneous Investors

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  • Zhenguo Lin
  • Yingchun Liu

Abstract

This article develops a theoretical framework and formulates a unified risk metric that integrates both real estate price risk and uncertainty of time on market (TOM). We demonstrate that real estate sellers with different degrees of financial distress face not only different marketing period risks, but also receive different return distributions upon successful sales. The major findings of this article can be summarized as follows. First, we show that real estate return and risk, which account for both price and TOM risk, are investor specific, varying over investors with different financial circumstances and holding periods. Second, the traditional valuation of real estate return and risk, which is based solely on the return distribution of a successful sale without considering the uncertainty of TOM and the investor's financial circumstances, underestimates real estate risk and exaggerates real estate return. Third, our empirical applications in both residential and commercial real estate markets show that the Sharpe ratio estimated by the traditional approach is seriously overstated—to the largest extent for investors with high financial distress. In addition, we find that, given the typical 5‐ to 7‐year holding period for real estate, the Sharpe ratios estimated by integrating both price and TOM risk are much in line with the performance of financial assets. These findings can help to explain the apparent “risk‐premium puzzle” in real estate.

Suggested Citation

  • Zhenguo Lin & Yingchun Liu, 2008. "Real Estate Returns and Risk with Heterogeneous Investors," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 36(4), pages 753-776, December.
  • Handle: RePEc:bla:reesec:v:36:y:2008:i:4:p:753-776
    DOI: 10.1111/j.1540-6229.2008.00229.x
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    File URL: https://doi.org/10.1111/j.1540-6229.2008.00229.x
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    References listed on IDEAS

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    1. Zhenguo Lin & Kerry D. Vandell, 2007. "Illiquidity and Pricing Biases in the Real Estate Market," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 35(3), pages 291-330, September.
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    5. Shaun Bond & Soosung Hwang & Zhenguo Lin & Kerry Vandell, 2007. "Marketing Period Risk in a Portfolio Context: Theory and Empirical Estimates from the UK Commercial Real Estate Market," The Journal of Real Estate Finance and Economics, Springer, vol. 34(4), pages 447-461, May.
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    8. Norman G. Miller, 1978. "Time on the Market and Selling Price," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 6(2), pages 164-174, June.
    9. Michael A. Arnold, 1999. "Search, Bargaining and Optimal Asking Prices," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 27(3), pages 453-481, September.
    10. Cauley, Stephen Day & Pavlov, Andrey D, 2002. "Rational Delays: The Case of Real Estate," The Journal of Real Estate Finance and Economics, Springer, vol. 24(1-2), pages 143-165, Jan.-Marc.
    11. David Collett & Colin Lizieri & Charles Ward, 2003. "Timing and the Holding Periods of Institutional Real Estate," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 31(2), pages 205-222, June.
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    13. Thomas J. Miceli, 1989. "The Optimal Duration of Real Estate Listing Contracts," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 17(3), pages 267-277, September.
    14. Ping Cheng & Zhenguo Lin & Yingchun Liu, 2008. "A Model of Time‐on‐Market and Real Estate Price Under Sequential Search with Recall," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 36(4), pages 813-843, December.
    15. Huang, Ming, 2003. "Liquidity shocks and equilibrium liquidity premia," Journal of Economic Theory, Elsevier, vol. 109(1), pages 104-129, March.
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    Cited by:

    1. Steven Devaney & David Scofield, 2015. "Liquidity and the drivers of search, due diligence and transaction times for UK commercial real estate investments," Journal of Property Research, Taylor & Francis Journals, vol. 32(4), pages 362-383, December.
    2. Chun-Kei Tsang & Wing-Keung Wong & Ira Horowitz, 2016. "Arbitrage opportunities, efficiency, and the role of risk preferences in the Hong Kong property market," Studies in Economics and Finance, Emerald Group Publishing, vol. 33(4), pages 735-754, October.
    3. Christian Rehring, 2012. "Real Estate in a Mixed‐Asset Portfolio: The Role of the Investment Horizon," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 40(1), pages 65-95, March.
    4. Ping Cheng & Zhenguo Lin & Yingchun Liu, 2008. "A Model of Time‐on‐Market and Real Estate Price Under Sequential Search with Recall," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 36(4), pages 813-843, December.
    5. Daisy J. Huang & Charles Ka Yui Leung & Chung-Yi Tse, 2018. "What Accounts for the Differences in Rent-Price Ratio and Turnover Rate? A Search-and-Matching Approach," The Journal of Real Estate Finance and Economics, Springer, vol. 57(3), pages 431-475, October.
    6. Gianluca Marcato, 2018. "Liquidity Pricing of Illiquid Assets," ERES eres2018_215, European Real Estate Society (ERES).
    7. Cheng, Ping & Lin, Zhenguo & Liu, Yingchun, 2010. "Illiquidity, transaction cost, and optimal holding period for real estate: Theory and application," Journal of Housing Economics, Elsevier, vol. 19(2), pages 109-118, June.
    8. Ping Cheng & Zhenguo Lin & Yingchun Liu, 2010. "Home Price, Time-on-Market, and Seller Heterogeneity Under Changing Market Conditions," The Journal of Real Estate Finance and Economics, Springer, vol. 41(3), pages 272-293, October.
    9. Charles-Olivier Amédée-Manesme & Fabrice Barthélémy & Philippe Bertrand & Jean-Luc Prigent, 2019. "Mixed-asset portfolio allocation under mean-reverting asset returns," Annals of Operations Research, Springer, vol. 281(1), pages 65-98, October.
    10. Cheng, Ping & Lin, Zhenguo & Liu, Yingchun, 2011. "Property delisting, housing cycle and pricing bias," Journal of Housing Economics, Elsevier, vol. 20(2), pages 152-157, June.
    11. Tsang, Chun-Kei & Wong, Wing-Keung & Horowitz, Ira, 2016. "A stochastic-dominance approach to determining the optimal home-size purchase: The case of Hong Kong," MPRA Paper 69175, University Library of Munich, Germany.

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