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Real estate market efficiencyStuart M. Locke aa Department of Accounting and Finance , University of Tasmania ,AustraliaPublished online: 27 Apr 2007.
To cite this article: Stuart M. Locke (1986) Real estate market efficiency, Land Development Studies,3:3, 171-178, DOI: 10.1080/02640828608723910
To link to this article: http://dx.doi.org/10.1080/02640828608723910
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Land Development Studies, 1986, 3, 171-178
Real estate market efficiencySTUART M. LOCKEDepartment of Accounting and Finance, University of Tasmania, Australia
Received August 1985
The application of modern portfolio theory to the investment in shares and bonds is integrally connectedwith the efficient market hypothesis. The requirement of multivariate normality of security returns is asufficient condition for equilibrium asset pricing models such as the capital asset pricing model totheoretical work. Nevertheless the empirical relevance in decision making is firmly based on the efficiencyof the capital market. If real estate investors are to avail themselves of these techniques it is first necessaryto ensure the requirements of the efficient market hypothesis are satisfied in the context of the propertymarket. This paper reports the results of such an inquiry into the British and Australian real estatemarkets.
Keywords: Multivariate portfolio theory, efficient market hypothesis, capital asset pricing, propertymarkets; Australia, Britain.
Portfolio theory is generally considered to be applicable to a broad spectrum of asset choice.Francis and Archer (1979, p.3) suggest it may, at least conceptually, be applied to a wide range ofasset selections, which include cars, houses and spouses. There is very little reported evidence ofsuch applications and the primary use is in the area of financial securities, especially shares.Within the institutional investor community, finance models have increased in acceptabilityand many portfolio managers are aware of, and use equilibrium asset pricing models for theirdealings with shares and bonds. Although a large proportion of these same organizations havelarge property portfolios, the approach adopted appears to be very different. This is certainlyreflected in the differing practices of the security analysts engaged in fundamental analysis andthe more 'street wise' approach of the valuers.
The reasons why the approaches to real estate portfolio management and financial securitiesportfolio management differ are unclear. Perhaps it is historical practices or perhaps portfoliotheory is not applicable to real estate. To address this latter possibility the first step is toinvestigate the nature of the market and determine whether it displays the necessarycharacteristics which are required as a precondition for the application of portfolio theory.These conditions need first to be explained.
Markets are of fundamental importance in all free enterprise and mixed economies. It is 1986 Land Development Studies Education Trust
through the market mechanism that demand and supply signals are revealed, tradesconsummated, and the levels of consumption, production and investment determined. Thesecurity market is a forum in which demand and supply of capital resources are matched. Theprice of securities resulting from the trades is an important signal to the suppliers and users ofcapital in their endeavours to construct investment portfolios and dispose of funds. It isimportant to know whether these market prices are efficient in the sense of embodying all therelevant information regarding securities which are traded. Lack of confidence in the prices willresult in the providers and users of the capital engaging in resource wasteful rent-seekingactivities to exploit any such inefficiencies.
An acceptance, by participants, that the mechanism by which security prices are established isefficient and reliable permits the development of decision rules and trading strategies which donot require alteration with each transaction. If, of course, participants were to alter theirobjectives then the decision rules and strategies'may require modification, but this isindependent of the reliability and efficiency of market prices. As is apparent, the practicalimplications of market efficiency are of considerable importance in the determination ofeconomic growth and welfare for a country. The efficiency of both the market for propertycompany shares and the market for the physical assets is analysed below and a comparisonmade between the two.
2. Efficient market hypothesis tests
Several statistical procedures for analysing market efficiency have been developed and these arecollectively referred to as efficient market hypothesis (EMH) studies. The appropriateness ofeach specific method depends to a significant extent on the level of efficiency which is beingconsidered. Conventionally the efficient market hypothesis is divided into three forms, whichhave varying degrees of'efficiency' associated with them. Dobbins and Witt (1983, Ch. 4) outlinein summary form many of the major studies which have been conducted.
The weak-form of the efficient market hypothesis states that current market prices fullyembody all the information available in the historical series of prices. In a formal sense thisrequires the expected price or expected price change to be independent of prior prices. The semi-strong form of the efficient market hypothesis requires the security prices to reflect fully allpublicly available information. This suggests a security price will alter on the announcement ofnew information and that no discernible reaction will be observed in the security price after theannouncement. The strong form of the efficient market hypothesis asserts that all informationwill be impounded in the price of a security. This suggests there is no inside information whichwill allow a trader to obtain abnormal returns.
As is readily apparent the procedures which are required to test the EMH empirically differbetween the forms. For example the weak-form will require an analysis of the distribution ormovement in security prices. This is what is commonly referred to as the random walk model.Semi-strong form EMH research will require an equilibrium model of security prices. This isalso the case for strong form tests. The difficulty which arises in the latter two instances is thatthe tests are inevitably joint tests of the equilibrium model and the form of the EMH which isunder investigation. There are many critiques (e.g. Ross, 1978) of the semi-strong and strong
Real estate market efficiency 173form tests which have been conducted to date. However, these are not of importance to thecurrent study which concentrates upon weak-form EMH testing.
The majority of the empirical EMH research has been conducted on stock exchange datarelating to shares and bonds. In the United Kingdom (Richards, 1979) and Australia (Ball,Brown, Finn and Officer, 1982) extensive tests have reached conclusions similar to thoseobtained in the United States of America (Copeland and Weston, 1983, Ch. 10), which supportacceptance of the weak form of the efficient market hypothesis. These tests have been applied tovarious size portfolios of shares and the evidence is in general confirmatory.
An acceptance of market efficiency has encouraged the adoption of portfolio theory andassociated equilibrium asset pricing models for the management of investment portfolios. Theextent to which the capital asset pricing model, beta, the security market line, and Markowitzdiversification are applied by portfolio managers is increasing. However, these developmentsappear only to relate to financial securities such as shares and bonds, and do not apply to othersecurities such as land, or bricks an