Jim Clayton

Rational Expectations, Market Fundamentals and Housing Price Volatility

This paper derives a forward-looking rational expectations house price model and empirically tests its ability to explain short-run fluctuations in real house prices. A novel approach to proxying the imputed rents of owner-occupied housing, as a function of observable housing market fundamentals, is combined with a housing market arbitrage relation to derive a present value model for real house prices. Tests of the rational expectations, nonlinear cross-equation restrictions reject the joint null hypothesis of rational expectations and the asset-based housing price model for quarterly, single-detached house prices in the city of Vancouver, British Columbia from 1979-1991. The model fails to fully capture observed house price dynamics in two real estate booms but tracks real house prices well in less volatile times, suggesting that prices may temporarily deviate from fundamental values in real estate price cycles. Copyright American Real Estate and Urban Economics Association.

Commercial Real Estate Valuation: Fundamentals Versus Investor Sentiment

This paper investigates the role of fundamentals and investor sentiment in commercial real estate valuation. In real estate markets, heterogeneous properties trade in illiquid, highly segmented and informationally inefficient local markets. Moreover, the inability to short sell private real estate restricts the ability of sophisticated traders to enter the market and eliminate mispricing. These characteristics would seem to render private real estate markets highly susceptible to sentiment-induced mispricing. Using error correction models to carefully model potential lags in the adjustment process, this paper extends previous work on cap rate dynamics by examining the extent to which fundamentals and investor sentiment help to explain the time-series variation in national-level cap rates. We find evidence that investor sentiment impacts pricing, even after controlling for changes in expected rental growth, equity risk premiums, T-bond yields, and lagged adjustments from long run equilibrium.

Are Housing Price Cycles Driven by Irrational Expectations

This paper investigates the extent to which condominium apartment prices are set in an efficient asset market. Unlike previous work that focuses on the time-series properties of measures of excess returns, the analysis is framed in terms of the changes in observable house prices over time. More precisely, the paper develops and applies a test of the joint null hypothesis of rational expectations, perfect markets, and no risk premium in the Vancouver condominium apartment market. The empirical results provide significant evidence against the joint null hypothesis. On average, ex post house price changes move in a direction opposite to their rational expectation. This approach offers a methodological advantage over the standard efficiency literature and is shown to provide a more powerful test of market efficiency than conventional return regressions. Another contribution of the paper is to characterize the time-series properties of deviations of condominium prices from those predicted by the risk-neutral rational expectations model, using cointegration and random coefficients techniques. Deviations in house price changes from their (risk-neutral) rational expectations are time varying, stationary, and related to the stage of the real estate price cycle.

REIT Returns and Pricing: The Small Cap Value Stock Factor

This study employs a variance decomposition approach to explore the investment characteristics of equity REITs within a multi‐factor model relating REIT returns to returns to small capitalization value stocks, small cap growth stocks, large cap stocks, bonds and private real estate. It also examines the changing nature of the return process over time, utilizing a finer partition of the stock market factor than many previous researchers have by distinguishing between small capital growth and small capital value stocks. This decomposition allows the effect of small stocks to be measured more accurately. In addition, this study is unique in that it incorporates a real estate factor at the monthly frequency, constructed from monthly REIT share price premium to NAV estimates. Our results show that REITs have a significant small capital value component, yet also exhibit a large sector‐specific component that has increased in importance in recent years. Conversely, REIT return volatility is not highly related to small capital growth stocks, and the contribution of large capital stock drivers to REIT volatility has declined over time. On a monthly level, private real estate returns play only a marginal role in explaining REIT volatility. Our results contribute to an improved understanding of the role played by REITs in portfolios diversified across asset classes.

Real Estate Comes of Age

Real estate has gained wider acceptance as a legitimate institutional investment. The asset class continues to grow and adopt many of the features of the broader capital markets. International strategies, private equity strategies [with general partner - limited partner promoted fee structures], public REIT corporate governance, structured debt products (commercial mortgage-backed securities and commercial real estate collateralized debt obligations), hedge funds, as well as commercial real estate index-based derivatives are among the topics covered in this issue. Today real estate must compete in the alternative space with private equity, hedge funds, infrastructure and more. Yet, as several of the articles in this edition conclude, real estate retains its distinct features as an asset class; the role of real estate as a portfolio risk reducer looks sustainable over the long-term. Over long and short time periods, its return patterns are rarely in close synchronization with stocks and bonds, despite the adoption of the financial tools and techniques of the broader capital markets. This paradox-further integration with the broader capital markets, yet distinct and separate financial behavior-is the underlying theme of nearly all the articles in the issue.

Real Estate’s Evolution as an Asset Class

In this introductory article, the editors of this issue examine the impact of the credit crisis on commercial and multifamily real estate and provide a post-crisis, evolutionary view of real estate as an asset class. This is done by putting the events of the last 18 months into a broad perspective and within a framework that encompasses these major themes: 1) capital market integration, financial leverage, and sentiment; 2) the “failure” of diversification; 3) innovations in real estate portfolio risk measurement and management; and 4) international real estate. The aim of the article is to help investors understand the evolving characteristics of the asset class and to help them improve the effectiveness of actions that anticipate, monitor, and manage risk. It also sets the stage for the collection of articles in this issue that offer new insights into how commercial and multifamily real estate investing lines up with assumptions about market efficiency, outlier risks, theories of diversification, and longer-term asset and risk allocation.

Mortgage Flows and Commercial Property Price Cycles

In this article, Clayton and Peng hypothesize that commercial real estate value appreciation affects commercial mortgage supply, which helps constitute a feedback loop between mortgage supply and real estate values that drives real estate cycles. Clayton and Peng estimate a two-equation reduced form of a structural model of mortgage demand and supply, using quarterly U.S. data from 1978 to 2008. The results indicate that past real estate value appreciation positively affects mortgage fund flows but not mortgage interest rates, which substantiates the effect of real estate value appreciation on the supply of mortgages.

Portfolio Strategy and Structure Take Center Stage: "How, What, Where, and When?" Replace "Why?"

Real estate has become more accepted as a basic building block of a well-diversified institutional portfolio over the past decade. The debate around the question “Why Real Estate?” has largely been put to rest. The most relevant research questions about the asset class now revolve around more detailed issues in optimal allocations under different situations and in light of new trends, and also around details of how implementation of a real estate allocation (i.e. the actual investments made) should be done and how it affects the risk/return characteristics of the final portfolio. The relevant new trends in the industry and the associated research questions are discussed.

New Horizons and Familiar Landscapes:New Capital Sources Confront Shifting Real Estate Fundamentals

Real estate has continued to evolve as an asset class. In this introduction to the special issue, the authors examine new sources of capital that have entered real estate, some of which have already had a large impact and others that have the potential to bring major changes in the future. While the capital market foundations of the asset class are changing, the traditional cycle in property fundamentals remains a distinguishing feature, albeit changed from past cycles. As new sources of capital encounter real estate’s fundamentals cycle, in-depth understanding of the asset class is imperative. The authors review these trends and suggest how the other articles in this special issue can help investors navigate this confluence of new and old.

The Changing Face of Real Estate InvestmentManagement

The real estate investment management industry has been undergoing a process of change over the last two decades. The market is far more transparent than it once was due to the availability of far more, and more detailed, market information. Combined with the increasing integration of real estate with the broader capital markets, this has led to a market that reacts more quickly to events, exhibits more volatility, and in which the nature of risk has changed. These ongoing changes in the market, combined with the lessons of the financial crisis, have resulted in risk management becoming a topic of primary importance in real estate investment. Changes in the nature of real estate risk and the increased emphasis on risk management have the potential to create substantial changes in the real estate investment management industry going forward. The greatest challenge for the industry will be cultural—an understanding of risk, its sources, and its management will need to become central to investment decision making.