The share market is known for its instantaneous price adjustments to new information, which eliminates the possibility of arbitrage opportunities. The housing market is different. Due to inefficiencies it is possible for the housing market to divert from an equilibrium price level sustained by fundamentals. These inefficiencies include a lack of quick adjustment on the
supply side, because of a construction lag in the process of building houses. The SR and MR time lag means that the adjustment will occur through prices.
At the same time information is not fully available, which complicates the search and decision process resulting in longer trade effectuation times. First of all houses are rarely traded, secondly there does not exist houses with the same attributes making it hard to compare investments, third the seller has a strong incentive not to give all available information, whereas it is likely that there exist asymmetry in knowledge between buyer and seller.
On the demand side a substantial search time must be expected making the individuals take longer time to adjust to their best suitable homes. This can be influenced by transaction costs and moving costs, making people moves less frequently. The real estate market is mostly consisting of small investors (private people) who rarely trade the good (low transaction frequency) making them inexperienced and amateurs having to make their biggest investment depending on limited and asymmetric information. They have little or no experience in what the fundamental value of the houses they are buying and selling are, and they very rarely calculate present value of their investment. At the same time investors rarely consider their alternatives, which include renting a similar house or constructing their own. In addition then the investment in a house is a lumpy investment giving credit restraints on the buyer who usually would have to sell the former residence.
Unlike the share market, the absence of short selling and derivatives concerning houses prevent informed traders from exploiting the mistakes of noise traders to be able to re-establish equilibrium. Compared to stocks, house prices tend to get relatively further away from the fundamental value, making the housing market relatively unstable and more likely to be bubbly (Smith, 2005).
The housing market is therefore not perfectly efficient, but that does not mean that the market for real estate is completely inefficient. To be so there would have to be serial correlation in house prices. As earlier presented then there was some evidence of serial correlation in the SR, but in the LR it did not seem to be the case. Therefore I will describe to which degree the housing market is efficient.
A perfectly efficient market is defined as where a security’s price equals its investment value at all times. However, we have already seen that this is not the case for the housing market.
Instead the term strongly efficient market regarding a market where asset price changes should be unpredictable since they only respond to new information, which by definition is
unpredictable. Price changes should therefore follow a random walk, which makes it impossible to forecast the returns on real estate. Expectations of returns are mathematically done through available information at time t, whereas a test could justify the predictability of house prices.
If it was possible to predict house prices then it would be able to make arbitrage in the market, whereas the housing market must be said to be only partly efficient. However, being an investor in the housing market is not without risk and since short selling is not possible and a house being a big investment then the arbitrage possibilities are limited. For the arbitrage to work people would have to know that other investors would be effective in doing the same and thereby on aggregated terms bring the market to its fundamental path. Combining that housing investors cannot expect others to arbitrage in the market they will hesitate to do so themselves. At the same time mortgage bankers have strong incentives typically influenced by bonuses and are under competitive pressure to keep lending, whereas there is a much stronger effect of using momentum and expecting others to follow.
There is therefore asymmetry in the psychological aspect of agents in the market making it impossible to arbitrage and a creation of reinforcing processes are very likely making the SR serial correlation lead to a possibility of forecasting SR returns. However, because of being away from the fundamental level, it must be expected that the correction will come at some point. The mean reverting process supports that the further away from equilibrium the riskier the market. This is due to the probability of decreases will increase the further away from fundamentals that house prices get.
8.1. Risks and instruments
The housing market includes risk and it grows with the size of the unexplained residual also known as the bubble element. Investing in houses is thought to be much riskier than to invest in many other assets due to the fact that houses to a much larger extent are financed by borrowed money, making the investment relatively more risky than stocks. It is therefore very important to have instruments that can manage risk. These tools are not present today, which makes an urgent need for diversification of the portfolio, which would make short selling and risk adjustment possible (Eichhiolz, 1998).
An alternative would be to develop a futures market, which would reduce the volatility of real house prices. Investors could then buy or sell real estate with much lower transactions cost
and be able to do arbitrage and making the housing market more efficient. Financial instruments would then to a larger extent be able to prevent housing bubbles and take out a major risk element for individuals (Capozza, 2002 and Farlow, 2004b).