Three Essays on the Efficiency of Real Estate Markets

This dissertation consists of three essays related to the efficiency of real estate markets.The first essay attempts to explain the causes of these inefficiencies by attributing them to unique characteristics of real estate markets. We consider an experimental asset market where all investors receive the same dividend from a known probability distribution. In particular we examine the impact of transaction costs, short selling restrictions, and divisibility of assets on market efficiency. We find that short selling restrictions prevent traders from reducing prices, contribute to prolonged bubbles, and hence lead to inefficient markets. Relaxing the short selling constraint increases the trading volume, reduces prices, increases the occurrence of bust cycles, but does not result in prices tracking fundamentals. Transaction costs do not exacerbate the inefficiency of the market. Conversely, they reduce the occurrence and magnitude of bubbles and cause prices to track fundamentals more closely. Imposing transaction costs also lowers trading volume. Introducing a more divisible asset reduces the magnitude of bust cycles and improves the overall efficiency of the market. We also design an experimental market where we combine these three attributes of real assets. We find the transaction prices in this experimental market to be higher, the boom and bust cycles to be longer and trading volume to be smaller compared to the experimental market where there are no transaction costs, short selling is allowed and the asset is divisible.The second essay examines the impact of the volatility of cash flows/dividends on the volatility of prices. We consider a simple experimental environment where subjects trade in an asset which provides dividends from a known probability distribution. The expected value of the dividends is identical in all experimental treatments. The treatments vary with respect to the volatility of dividends. We find that when dividends are more volatile, transaction prices are lower. We also find that the volatility of prices is lower in the treatment with highly volatile dividends. In addition, as expected, trading volume is lower when cash flows are less volatile.In the third essay, we use theoretical models of land prices and house price volatility in urban areas previously developed in the literature and investigate the differences in appreciation of house prices and their volatility across different geographic regions of the United States. The variables that are shown in the models to be important in affecting the variance of housing returns are identified. The empirical investigation of these variables shows that, as expected by the model, the variance of housing return is found to be positively and significantly related to the variance of household income, land leverage, and transportation costs. The variance of housing returns is found to be negatively and significantly related to the growth of household income and the real estate transfer tax rate.