The Relationships between Real Estate Price and Expected Financial Asset Risk and Return: Theory and Empirical Evidence

Abstract

In pricing real estate with indifference pricing approach, market incompleteness significantly distorts the conventional pricing relationships between real estate and financial asset. In this paper, we focus on the pricing implication of market comovement because comovement tends to be stronger in financial crisis when investors are especially sensitive to price declines. We find that real estate price increases with expected financial asset return but only in weak market comovement (i.e., a normal market environment) when investors enjoy diversification benefit. When market comovement is strong, real estate price strictly declines with expected financial asset return. More importantly, contrary to the conventional positive relationship, real estate price generally declines with expected financial asset risk. Even when market comovement is strong, real estate price only increases with financial asset risk when the risk is low but eventually declines with the risk when it becomes high. These nonlinear price relationships highlight the importance of asset market comovement that is usually overlooked by conventional option pricing model developed in complete market setting.

Keywords: Comovement, Indifference Pricing, Incomplete Market, Real Estate, Risk and Return

JEL Classification: G1, G12