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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

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Land Development Studies, 1986, 3, 171-178

Real estate market efficiency

STUART M. LOCKEDepartment of Accounting and Finance, University of Tasmania, Australia

Received August 1985

Summary

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.

1. Introduction

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

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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

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Real estate market efficiency 173

form 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 and mortar - the property market. A prerequisite for thesuccessful use of these models is the establishment of market efficiency. It is also desirable for thereturns to be approximately 'normally distributed'. This permits their complete description, in astatistical sense, by reference to their mean and standard deviation. Further multivariatenormality allows securities to be linearly related (Fama, 1976, pp. 69-72) and this encouragesthe application of equilibrium asset pricing models such as the market model and the capitalasset pricing model.

3. Property shares and real property

There are a number of companies listed on the Stock Exchange which invest in property whichare in essence property investment trusts. The shares in these companies are aggregatedtogether to form an index of property company returns. The British FT Property Index, theAustralian Statex Accumulation Property Index and thirteen Australian listed property trustsare chosen as financial securities in the property sector. To represent real property prices theBritish Jones Lang Wootton (1981) indices are used. There is no Jones Lang and Wootton indexfor Australia as yet; however, alternative sources are available.

Richard Ellis and Associates (1984) is now publishing a series of indices of real property pricesin Australia. The Victorian Valuer-General's Department also publishes in their annual reporta series of indices which are based on real estate sales. The Richard Ellis (RE) Capital Index andtwo Valuer-General's (Vic) indices are chosen as being most closely comparable to the JonesLang and Wootton (JLW) indices.

First, the returns are calculated (ROR program in FITS) on a monthly basis according to:

Rt=(P,-Pt-i)/Pt-i (1)

where Rt is the rate of return for period t, Pt is the price (value) at the end of period t, and P, _ x isthe price (value) at the beginning of period t.

Second, two forms of test are conducted to ascertain whether the returns of the variousproperty 'securities' move in accordance with the requirements necessary for weak formefficiency. A runs test and an autocorrelation test are conducted on each of the securities.

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3.1. Autocorrelation test

For returns to follow a random walk there must not be significant serial correlation betweenobservations. The series of individual returns of each security are subject to the calculation andexamination of their autocorrelation function, to determine the extent and significance of theserial correlation which they exhibit. The hypothesis

Ho: The autocorrelation is not significantly different from zero;

is tested at the 95% confidence interval (Box-Jenkins Ident program of SPSS).The results are presented in Table 1. The financial assets behave in a way which is consistent

with the findings of previous stockmarket EMH studies. They do not display significantamounts of serial correlation. Terrace Property trust is an exception. It is to be expected thatgiven finite sampling periods some exceptions will occur randomly. At this stage it is best to note

Table 1. Randomness of returns - autocorrelation test.

Security

Property indicesFT Property TrustStatex Property Trust

Property trustsASC PropertyCanberra CommercialCanberra Commercial #2PML PropertyStocks & Holdings PropertyGeneral PropertyNatprops PropertySchroder Darling PropertyEquitable Property # 1Equitable Property #3Stockland PropertyWestfield PropertyTerrace Property

Physical propertyJLW Office CapitalJLW Shop CapitalJLW Industrial CapitalJLW Agricultural CapitalJLW CapitalRE CapitalVIC CommerceVIC Industry

95% Confidence intervalacceptance of Ho

YesYes

YesYesYesYesYesYesYesYesYesYesYesYesNo

NoNoNoNoNoYesYesYes

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Real estate market efficiency 175

its occurrence and keep it in mind when considering further tests. The physical real estate indiceswhich are grouped together, split neatly between British and Australian data. This does warrantfurther investigation and is mentioned again in the conclusion.

The random walk theory is often considered to be a sufficient condition for the weak-form ofthe EMH. However, it is possible to think of situations where a series fails to fulfil therequirements of a random walk but is still compatible with the EMH. 'For example, theobservation that large price changes tend to be followed by more large price changes (but not ina predictable direction) would violate the random walk, but not the weak-form of marketefficiency' (Dyckman, Downes and Magee, 1974, p. 17).

3.2. Runs tests

The runs test, less restrictive than the autocorrelation test, is a very useful method of analysis asit is a sufficient condition for weak form EMH testing. The actual statement which is beingconsidered is 'that the expected value (or average) of today's price change is completelyindependent of all prior prices' (Dyckman, Downes and Magee, 1974, p. 17). If there is evidenceof a systematic pattern in the sequence of returns then the null hypothesis

Ho: the sequence of returns is random;

will be rejected. If this is the case then it will be possible to devise a trading rule based on apredetermined filter which will result in the earning of positive abnormal returns.

The results of the runs tests (NPAR program of SPSS) are tabulated below in Table 2. It isreadily apparent that there is a difference between the results of the financial securities and thoseof the physical assets. The former group, without exception, satisfied the requirements of the testwhile the latter group again divided along international boundaries.

3.3. Normal distribution test

A random series is often considered to be normally distributed. It is of course not necessary for arandom series to follow a normal distribution, but it certainly is useful if it is found to do so.Normality permits a full description of the series by reference to the mean and standarddeviation and encourages the use of parametric statistical procedures, rather than forcing areliance on less powerful non-parametric statistics. It is also of considerable importance ifportfolio theory models are to be used. A Kolmogorov-Smirnov two tail test (NPARprogram of SPSS) is utilized and a 95% confidence level, the same as for the two previous tests,is chosen as appropriate to test the hypothesis

Ho: the distribution is normal.

The results for this test as presented in Table 3 are not as clear as for the two previoushypotheses. The two indices are found to be normal whilst three of the property companies failto satisfy the test criterion. The real property indices, with the exception of the RE CapitalIndex, did pass the test, and accordingly are accepted as conforming to a normal distribution.

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Table 2. Randomness of returns - runs test.

Security

Property indicesFT Property IndexStatex Property Index

Property trustsASC PropertyCanberra CommercialCanberra Commercial #2PML PropertyStocks & Holdings PropertyGeneral PropertyNatprops PropertySchroder Darling PropertyEquitable Property # 1Equitable Property #3Stockland PropertyWestfield PropertyTerrace Property

Physical propertyJLW Office CapitalJLW Shop CapitalJLW Industrial CapitalJLW Agricultural CapitalJLW CapitalVIC CommercialVIC IndustrialRE Capital

95% Confidence intervalacceptance of Ho

YesYes

YesYesYesYesYesYesYesYesYesYesYesYesYes

NoNoNoNoNoYesYesYes

Conclusion

The financial securities affirmed what would reasonably have been expected given the findingsof previous EMH studies. The two weak-form tests are satisfied and the majority of thesecurities are found to be normally distributed. The rejection of three companies does not provethat their returns are not normal. It only says that for this specific sample the returns are notnormally distributed. This is the same story for Terrace Property with regard to theautocorrelation test.

Real property displays quite different characteristics as compared with the financial assets.There is also a striking difference between the test results on British and Australian data. Thefailure of the JLW indices to conform to the minimum requirements of the efficient markethypothesis strongly suggests that the application of portfolio theory to the management of suchproperty portfolios will not be successful. In Australia the opposite interpretation appears quite

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Real estate market efficiency 177

Table 3. Returns normality test.

Security

Property indicesFT Property IndexStatex Property Index

Property trustsASC PropertyCanberra CommercialCanberra Commercial # 2PML PropertyStocks & Holdings PropertyGeneral PropertyNatprops PropertySchroder Darling PropertyEquitable Property* 1Equitable Property # 3Stockland PropertyWestfield Property

Physical propertyJLW Office CapitalJLW Shop CapitalJLW Industrial CapitalJLW Agricultural CapitalJLW CapitalRE CapitalVIC CommercialVIC Industry

95% Confidence intervalacceptance of Ho

YesYes

YesNoNoYesYesYesNoYesNoYesYesYes

YesYesYesYesYesNoYesYes

reasonable. However, the lack of normality gives rise to the practical issue that it would not bean easy matter to implement.

The striking anomaly between British and Australian results must be a cause for somereservation from the ready acceptance of the obvious conclusion - Australian real propertymarket is efficient and the British real property market is inefficient. This is an area for furtherresearch. It is nevertheless possible to suggest two potentially important distinctions.

Firstly, the Australian data are primarily transaction-based whereas the British data arelargely based on valuations. The absence of sufficient arm's length transactions for JLW figuresmay result in comparable valuations being the basis of valuations, rather than comparable salesas the basis of valuation. This will inevitably lead to less volatility in the valuations and this willflow through to the indices.

Secondly, the procedure by which valuations are made in Australia and Britain does appearto be similar although in the area of commercial valuations there is a considerable difference in

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the length of leases. Australian leases are normally for two or three years. British leases are inmost instances considerably longer- seven to twenty-one years - and are subject to less frequentreviews. The result of this may well be to keep these valuations on a more steady path than thosein Australia.

References

Ball, R., Brown, P., Finn, P.J. and Officer, R.R. (1980) Share Markets and Portfolio Theory, University ofQueensland.

Castagna, A.D., Gerber, C.P. and Greenwood, C.H. (1983) The FITS System, Prentice-Hall.Copeland, T.E. and Weston, J.F. (1983) Financial Theory and Corporate Policy, Addison-Wesley.Dobbins, R. and Witt, S.F. (1983) Portfolio Theory and Investment Management, Martin Robertson,

Oxford.Dyckman, T.R., Downes, D.H. and Magee, R.P. (1974) Efficient Capital Markets and Accounting,

Prentice-Hall.Fama, E.F. (1976) Foundations of Finance, Basil Blackwell.Francis, J.C. and Archer, S.H. (1979) Portfolio Analysis, Prentice-Hall.Hull, C.H. and Nie, N.H. (1981) SPSS update 7-9, McGraw-Hill.Jones Lang Wootton, JLW Property Index, London.Jones Lang Wootton (1984) JLW Index, London.Richard Ellis (1984) Australian Property Index. Part 1 Melbourne, Melbourne.Richards, P. (1979) UK and European Share Price Behaviour: The Evidence, Kogan Page.Ross, S. (1978) The Current Status of the Capital Asset Pricing Model (CAPM), Journal of Finance 33 (3),

885-901.Valuer-General's Office, Victoria, Property Sales Statistics, Melbourne.

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