Does (and What) Illiquidity Matter for Real Estate Prices? Measure and Evidence

Abstract

Using a national sample of transactions in 24 major office markets in the U.S. from 1995 to 2010, this paper shows that illiquidity, especially the search cost component of illiquidity, is an important determinant of expected returns in real estate. We propose two novel measures to capture the price impact and search cost aspects of illiquidity in the real estate market, both of which are easily obtainable from price and volume data. At the regional market level, the price impact measure, which reflects the degree of supply and demand imbalance, is positively correlated with the proportion of high vacancy transactions and negatively related to transaction volume and the proportion of tax-deferred transactions. The search cost measure is strongly positively correlated with time-on-the-market, high vacancy, tax-deferred and out-of-state buyer proportion and is negatively correlated with the proportion of auction sales. Based on both quarterly hedonic price index (estimated from the transaction data) and the average quarterly transaction price, we find that there is a higher expected return in the market with a high price impact and search cost. The illiquidity premium is driven by the bust period, with a 10% increase in either the price impact or search cost measure leading to more than 4 percentage point increase in the annualized expected return in the cross section. Search cost is particularly relevant for understanding real estate prices for non-Class A buildings and during the 2008 financial crisis. We also document flight-to-quality (-liquidity) from non-Class A to Class A (i.e., investment grade) market during the crisis.