The Pennsylvania State University The Graduate School The Mary Jean and Frank P. Smeal College of Business ESSAYS ON MARKET FRICTIONS IN THE REAL ESTATE MARKET A Dissertation in Business Administration by Sun Young Park Copyright 2012 Sun Young Park Submitted in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy August 2012 The dissertation of Sun Young Park was reviewed and approved* by the following: Brent W. Ambrose Smeal Professor of Real Estate Head of Smeal College Ph.D. Program Dissertation Adviser Chair of Committee Austin J. Jaffe Chair, Department of Risk Management Philip H. Sieg Professor of Business Administration N. Edward Coulson King Faculty Fellow and Professor of Real Estate Economics Jiro Yoshida Assistant Professor of Business Jingzhi Huang Associate Professor of Finance and McKinley Professor of Business *Signatures are on file in the Graduate School ABSTRACT The real estate market is generally considered a less complete asset market than other financial asset markets in that real estate assets carry higher holding costs than other financial assets do. Thus, the real estate market is a good laboratory in which to explore the topic of market frictions. If a market were perfectly liquid such that no market frictions exist, the efficient market hypothesis would hold. However, as the 2007–2008 financial crisis has shown, market frictions arise for various reasons: asymmetric information, transaction costs, and financial constraints. The law of one price does not hold under the existence of market frictions. Thus, market frictions have important implications for the limits of arbitrage. It is important to understand the impact of market frictions and the ways in which they call into question the principles of classical economics. In order to examine market frictions, I focus on two categories: liquidity and segmentation. My dissertation offers a consideration of market frictions as follows: Chapter 1 presents an overview of market frictions in the real estate market together with an outline of the dissertation; Chapter 2 examines the spill-over impact of liquidity shocks in the commercial real estate market; Chapter 3 considers market segmentation by investor type in the commercial real estate market; Chapter 4 focuses on the liquidity spiral between market liquidity and loss aversion; and Chapter 5 presents concluding remarks. iv TABLE OF CONTENTS LIST OF FIGURES ............................................................................................................................................ vi LIST OF TABLES ............................................................................................................................................. vii ACKNOWLEDGEMENTS ............................................................................................................................ viii Chapter 1. Overview of Market Frictions in the Real Estate Market ....................................................... 1 Chapter 2. The Spill-Over Impact of Liquidity Shocks in the Commercial Real Estate Market........ 6 Literature Review ........................................................................................................................................ 8 Liquidity Measures ................................................................................................................................... 13 Stock Market ............................................................................................................................ 13 CDS Market .............................................................................................................................. 14 Bond Market ............................................................................................................................. 15 Underlying Assets (Private Market) ................................................................................... 16 Study Design .............................................................................................................................................. 18 Descriptive Statistics ................................................................................................................................ 19 Vector Auto Regression ........................................................................................................................... 21 CDS Market .............................................................................................................................. 21 Stock and Bond Markets ........................................................................................................ 23 Underlying-Asset Market ...................................................................................................... 24 Granger Causality Test ............................................................................................................................. 25 Impulse Response Function .................................................................................................................... 26 Variance Decomposition ......................................................................................................................... 27 Robustness Check ..................................................................................................................................... 29 Summary of Findings ............................................................................................................................... 31 Chapter 3. Does the Law of One Price Hold in Heterogeneous Asset Markets? ................................. 52 Literature Review ...................................................................................................................................... 56 Segmentation Type ................................................................................................................................... 60 Hypotheses .................................................................................................................................................. 61 Data............................................................................................................................................................... 62 Methodology .............................................................................................................................................. 63 v Summary Statistics .................................................................................................................................... 69 Empirical Results ...................................................................................................................................... 70 Type I Segmentation ............................................................................................................... 70 Type II and Type III segmentation ...................................................................................... 75 Summary of Findings ............................................................................................................................... 77 Chapter 4. Loss Aversion and Market Liquidity in the Commercial Real Estate Market ............... 104 Literature Review ................................................................................................................................... 107 Methodology ........................................................................................................................................... 110 Loss Aversion and Liquidity Measure ............................................................................................... 112 Descriptive Statistics ............................................................................................................................. 115 Empirical Results ................................................................................................................................... 117 Loss Aversion and Private Market Liquidity ................................................................. 117 Loss Aversion and Stock Market Liquidity ................................................................... 120 Loss Aversion and Financial Constraints ....................................................................... 124 Summary of Findings ............................................................................................................................ 126 Chapter 5. Concluding Remarks .................................................................................................................. 134 Bibliography ..................................................................................................................................................... 137 vi LIST OF FIGURES Figure 2-1: Monthly Time-Series of the OfferClosedSP ............................................................. 33 Figure 2-2: Response of REIT to Generalized One SD Shock in BOND ..................................... 34 Figure 2-3: Response of BOND to Generalized One SD Shock in REIT ..................................... 35 Figure 2-4: Response of CDS to Generalized One SD Shock in BOND ...................................... 35 Figure 2-5: Response of BOND to Generalized One SD shock in the Private Market ............. 36 Figure 2-6: Response of Private Market to Generalized One SD Shock in BOND ................... 36 Figure 2-7: Forecast Variance Decomposition for CDS ..................................................................