Law of Two Prices? Revisiting the Noise Trader Model of NAV Premiums

Abstract

This dissertation studies the US real estate investment trust (REIT) market to empirically examine several conditions of the noise trader model (NTM) — a behavioral theory that purports to explain departures of listed property share prices from their net asset values (NAV spreads). First, we demonstrate that after controlling for divergent rates of price discovery between listed and direct property markets, REIT prices correct toward an equilibrium relationship with NAVs — a persistent premium; these price corrections are consistent with NTM but contradict prior studies which find only unidirectional corrections of NAVs toward prices. Next, we find disaggregated measures of investor sentiment can help explain NAV spreads. Furthermore, individual investor sentiment appears more correlated with NAV spreads than institutional investor sentiment. While the relationships are weak and somewhat inconsistent, these findings are in line with NTM’s predictions. However, after controlling for fundamental information and standard asset pricing factors, the residual (considered irrational) component of sentiment offers insignificant supplementary explanation; this result severely challenges NTM’s relevance. Our findings elicit greater inquiries on the operationalization of sentiment, the risk profile of listed real estate, and the rationality of market risk pricing.