Residential Buildings and the Cost of Construction: New Evidence on the Efficiency of the Housing Market

Abstract

This paper examines whether housing markets are efficient by focusing on two equilibrium conditions that govern the implicit market for residential buildings, where building is defined as the physical structure apart from the land on which it rests. It is shown that in the long run equilibrium the price of a newly constructed building equals current construction costs, while the price of an older building also depends on past and current values of the relative cost of vacant land to capital. In addition, with efficient markets in equilibrium the expected risk adjusted rates of return across assets will be equal. Building off of these equilibrium conditions, the principal testable hypothesis is that any deviations between new building prices and construction costs should disappear more quickly than the time required for construction. A second testable hypothesis is that following a shock different vintage building prices should converge back to their long run values at a similar rate.

JEL Classification: R31