A new paradigm for real estate valuation?

AuthorDavid Wyman, Maury Seldin, Elaine Worzala
Publication Date12 Jul 2011
A new paradigm for real estate
David Wyman
Spiro Institute for Entrepreneurship and Leadership, Clemson,
South Carolina, USA
Maury Seldin
The Homer Hoyt Institute, North Palm Beach, Florida, USA, and
Elaine Worzala
Richard H. Pennell Center for Real Estate Development, Clemson University,
Clemson, South Carolina, USA
Purpose – The purpose of this exploratory paper is to examine the efficient market theories and to
argue that a new paradigm or an expanded paradigm is needed for the valuation of real estate. This
may actually not be a new paradigm but it may be necessary to go back in time to make the valuation
models that are used more realistic and to try to include the realities that there are many diverse actors
in the real estate marketplace and their actions are important and should not be assumed away.
Behavior matters and the models for pricing real estate need to take this into account.
Design/methodology/approach – The paper examines some of the emerging models in other
disciplines and works to relate them to the real estate marketplace in general but, more importantly, to
help to explain the most recent bust of the global real estate markets.
Findings – The paper finds that there is a need to consider an alternative paradigm for the valuation
of real estate and complexity theory as well as the adaptive system models that specifically take into
account that the various actors in a real estate marketplace could be used to help better explain the
emergent nature of real estate values.
Originality/value – This is the first paper to one’s knowledge that argues for a shift in thinking to
include complexity economics and agent-based modeling as potential solutions to gain a better
understanding of how real estate markets react.
Keywords Efficient markets,Complexity theory, Valuation theory,Real estate cycles,
Property marketbubbles, Adaptive system theory, Real estate
Paper type Conceptual paper
The dominant economic paradigm of the last 40 years has focused on an efficient
markets theory where all available information is capitalized into real estate prices.
Gau (1987) takes the position:
[...] that the concept of efficient real estate markets should be the working paradigm for real
estate research and analysis. I will argue that, even with their potential imperfections, real
estate markets can best be modeled at this time in terms of efficient markets. Such a theory is
not capable of describing perfectly all behavior observed in these markets, however that is
not required for a theory to be a useful paradigm (Gau, 1987, p. 2).
This perspective is supplemented by Friedman’s (1953) thesis that the use of
unrealistic assumptions is irrelevant; instead a theory should be tested based on the
The current issue and full text archive of this journal is available at
A new paradigm
for real estate
Received December 2010
Accepted March 2011
Journal of Property Investment &
Vol. 29 No. 4/5, 2011
pp. 341-358
qEmerald Group Publishing Limited
DOI 10.1108/14635781111150286
accuracy of its predictions. Friedman’s argument effectively protects the theoretical
constructs underlying the theory of efficient markets including assumptions of the
rational man, perfect information, and profit maximization. Research has focused on
the three types of efficient markets – ranging from the weak form efficiency where
past market prices are considered, to semi-strong efficiency where public information
is also included, to strong efficiency where all public and private information is
included in the setting of market prices (Gau, 1987). In the strong form of a perfectly
efficient real estate market, the market price of an asset reflects all the new-value
affecting information (Lusht, 1986). In essence, “price equals value.” Lusht (1986)
explains that in a perfectly efficient market, technical and fundamental analysis is
worthless; the appraiser should be paid to only gather and report information. One
advantage of a paradigm based on market efficiency is that it allows economists to
borrow tools from the field of physics to produce a deductive-based, mathematical
model to explain our economic system. Orthodox efficient market theoreticians believe
that markets cannot be beaten and that financial prices follow no discernible pattern,
i.e. that prices follow a random walk where past price movements do not provide clues
about future price movements (Beinhocker, 2006). Black (1986, p. 533) suggests that
noise can cause prices to deviate from the fundamental level in the short term, but that
the “farther the price of a stock moves away from value, the faster it will tend to move
back.” However, he takes a wide latitude in his definition of an efficient market “as one
in which price is within a factor of 2 of value, i.e. the price is more than half of value and
less than twice value” (Black, 1986, p. 532).
Kinnard (1968, p. 173) observes that “real estate decisions are different” from other
business decisions due to the innate characteristics of real estate. It is a highly
differentiated product with each specific site unique and fixed in location. He points out
that real estate is a durable, long-term asset, which means that development decisions
require complex forecasts of net income in dynamic and changing markets. The
buyers, especially in residential markets, are typically only sporadic players in the
market and “frequently unsophisticated in their decision behavior” (Kinnard, 1968,
p. 174).
The financial elements of real estate markets also make them differ fundamentally
from stock markets. Typically, a real estate transaction requires access to relatively
large amounts of capital (Kinnard, 1968) and the financial marketplace displays
inefficient qualities including high transaction costs, the lag in supply of properties in
response to increasing demand and the lack of an organized market for short selling
(Xiao and Tan, 2007). In addition, real estate investments incur holding costs in the
form of taxes as well as borrowing costs. For example, an acre of raw land bought for
$200,000 with an 80 percent loan to value ratio and a 6 percent annual interest rate with
a property tax rate of 1 percent would have to sell for $231,600 one year later just to
breakeven, all else being equal (10 percent commission fee ¼$20,000) þ($160,000
loan £6 percent interest ¼$9,600) þ(1 percent property tax £$200,000 ¼$2,000).
Such a calculation does not include any opportunity cost of losing interest on the
$40,000 down payment, nor the fact that the commission will actually be slightly
higher as it is paid on the new sale price.
Nevertheless, despite the dramatic capital gain that is required to break even in a
short term real estate investment, property markets have recorded rare, but spectacular
bubbles. Vanderblue (1927) observes that property bubbles raged along the lower East

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