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Tests on Real Estate Market Efficiency

 

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Abstract

This study performs tests on the weak form and semi strong form of market efficiency on the residential property market in Auckland, New Zealand. These tests were done by analysing an index constructed from repeated property sales, and also using a trading rule to predict for any underpriced properties. It was found that the results did not provide enough evidence to fully reject these forms of market efficiencies. The excess returns of the properties were found to be unpredictable and the profits identified by the trading rule could not be exploited.

However the tests conducted, show that the real returns from the appreciation of the residential property market are predictable and the hedonic pricing model used in the trading rule analysis performed quite well for pricing and as a base line for identifying underpriced properties. The techniques used in this analysis can be useful to assist investors in making more informative decisions and with some diligence, exploit these inefficiencies in the property market.

Contents

Introduction

Testing the weak form of Market efficiency

Testing the Semi-Strong form of Market efficiency
Conclusion
References


Introduction

The objective of this study is to rigorously test the real estate market efficiency in Auckland, New Zealand. Throughout the year 2003, there has been an increasing interest and media coverage of the residential property market, as prices have dramatically increased to record levels. And since there isn’t a known study performed on the efficiency of the New Zealand real estate market, it is hoped that an analysis may yield worthwhile results that may be of interest to academics and prinvestors.

As a first step of this analysis the definition of an efficient market has to be determined, Gau (1987) states that the concepts of market efficiency is generally based on Fama’s assertion of the three degrees of informational market efficiency, the weak form, semi-strong form, and strong from of efficiency. These degrees of market efficiency may be better explained by Brealey et al (2001), they state that the weak-form efficiency, is when no above normal profits can be made by trading on the past market information or simply that prices exhibit a random walk.

Secondly the semi-strong form efficiency implies that past information and all publicly available information is already reflected in the current prices. And lastly the Strong-form efficiency implies that the market has reacted to all available information, and no one however diligent can expect to earn superior profits. Jenson (1978) further contributes to this concept of market efficiency by arguing that, no matter what information investors are acting on, no economic profits can be consistently exploited by acting on this information, in that any abnormal returns should be justified by equivalent high risks (Gau, 1987).

According to Guntermann and Smith (2001), there are three main reasons why a real estate market is not efficient. Unlike the securities and commodities market, the real estate market is not standardized in the sense that each property is unique, so returns are difficult to estimate, and making asset pricing inaccurate. In addition properties are traded less frequently than other securities, so the fundamental prices are difficult to observe. Furthermore actual property pricing is mainly based on lagged information from transactions and mostly applied by using a rule of thumb, i.e. Based more on recent property sales price on relatively similar properties and buyer experience. So the real estate market prices may not reflect the true prices that are determined by demand and supply, and other market fundamentals.

There are numerous studies on the real estate market that tests the weak and semi strong form of market efficiencies, and thus numerous methods exist. In 1989 Case and Shiller tested the weak form efficiency in the property market of single family homes based on four states in America, and found that the excess returns are predictable based on the past returns. And in a recent paper by Jane Londerville (1998), she uses an intuitive trading rule adapted from Linneman (1986) to test the semi strong form of efficiency. In that paper she identifies potentially underpriced apartment buildings from using past and current information in actual sale prices, and tests whether those underpriced apartments exhibit higher future excess returns. I propose to test these two forms of real estate market efficiency by following similar methods undertaken by Case & Shiller, and Londerville.


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