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Housing Booms and the Return to Salient Fundamentals

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The first price of a repeat pair is widely recognized as a salient reference price. We show that fundamentals at the date of the first sale are salient at time of the second sale. We propose that any expectations about price appreciation will be tested against change in fundamentals realized after the purchase date. The salient gap is defined as the difference between change in market value and change in fundamental value, both between the two sales. A positive salient gap that opens up during a boom should rationally increase the probability of sale and reduce market value.

Connecticut data show that the probability of sale is a significant positive function of the salient gap for repeat sales, whereas the relationship is weaker for all sales, supporting the salience of the date of the first sale. When the salient gap is introduced into a model of the second sales price, we find that sales with gains are discounted by 6% on average relative to losses and by an additional 10% the presence of a positive salient gap. The discount is significantly larger (about 3% more) for a big positive gap. Analysis of the relationships to the salient gap would not be possible using gap variables developed in previous literature.

These results are robust to a number of model specifications and to controls for the quality of the property traded. However, even if the results are entirely due to unobservable quality (market prices reflect trades of lower quality properties with gains) they still show that the market is influenced by salient fundamentals and that properties with gains are important to the return to fundamentals.

Quantitative easing created large negative gaps in Connecticut after 2008 and these are associated with a shift in market behavior. The probability of sale is lower in the presence of large negative gaps and there is more uniformity in responses of sales to the gap. This suggests that Fed policy reduced income to real estate professionals reliant on trading.

Biography

John M. Clapp is a Professor of Finance and Real Estate at the University of Connecticut where he teaches real estate markets as a source of cash flows. These valuation fundamentals arise from spatial relationships between supply and demand in local residential and commercial markets. His statistical methods for tracking the evolution of property prices over space and time were featured at a meeting of the International Association of Assessing Officers (IAAO) in 2008, and subsequently published in the Journal of Property Tax Assessment and Administration. His foundational research on valuation has resulted in numerous articles in scholarly journals including The Journal of Urban Economics, Real Estate Economics, Regional Science, Economic Journal, The Journal of Real Estate Finance and Economics, and the Journal of the American Statistical Association. They have assisted with analysis of the aging of the housing stock, the forces driving development of urban areas, the value of public schools and methods for property tax assessment.

Professor Clapp’s current research seeks to value the option to redevelop the existing bundle of property characteristics. This work establishes that traditional valuation methods omit variables designed to capture the proportion of value related to redevelopment options. He served as Director for the Center for Real Estate and Urban Economic Studies from 2009 – 2012. He received his B.A. in economics from Harvard College, and a MBA and Ph.D. from Columbia University.

This talk is part of the Land Economy Departmental Seminar Series series.

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