Rational Predictability of Real Estate Prices

Abstract

Serial correlations in asset prices are often associated with irrational investment decisions (e.g., speculative bubbles) or inefficient markets. This paper shows that even asset prices determined rationally in an efficient market become predictable if underlying cash flows contain predictable components. In particular, I show that cash flows from real estate tend to contain a predictable “overshooting” component, due to slow adjustments in asset supply. Such predictable cash flows result in overshooting prices of real estate. Even though rational capitalization rates counteract the overshooting, the property price still exhibits predictability. The analysis indicates that the rational benchmark price must be carefully modeled when one tests irrationality or inefficiency in asset prices.