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Property market frictions

The property spread exists because property derivatives cannot be perfectly replicated by trading actual property. The frictions that inhibit perfect replication bear investigation. These frictions define arbitrage free price bounds for the property spread. Consider the following three basic market frictions:

  • Transaction costs

  • Transaction time

  • Short sale constraint

We look at property exclusively from an investment perspective without a consumption component. To examine the effect of each of these frictions on the willingness of market participants to pay, we introduce two counterparties: an investor and a hedger. The investor buys property and sells at a given investment horizon. The hedger, on the other hand, owns property but is worried about a market downturn. Hence he sells his property and buys them back at the end of the hedge period.

If these market participants engage in property derivatives rather than physical assets, the price considerations are as follows: the investor, buying a derivative contract, is concerned about paying too high a property spread. The hedger, selling the derivative contract, is worried about too low a property spread. Keeping this in mind, we consider each friction and its implication on the investor and the hedger.

Transaction costs

For both the investor and the hedger, it is costly to trade physical property.3 Transaction costs typi-

cally include agent’s fees, taxes, legal fees and registration fees. For the US, aggregate agent’s fees for

housing transactions range from 3% to 6% as in DiPasquale and Wheaton (1996). Furthermore, stamp

duty is levied in many US states and in the UK, and similar ad valorem taxes are levied in most other

jurisdictions. Moreover, in both the US and the UK, lawyers perform conveyancing, and substantial

legal fees can be incurred. Finally, registration fees are levied by local governments. In OECD countries,

roundtrip transaction costs are generally estimated to range from 6% to 12% as in Quigley (2002), Cun-

ningham and Hendershott (1984) and Malatesta and Hess (1986). However, technologies such as online

marketplaces have already begun to reduce some of these costs for homeowners. In 2007, practitioners

3Management and maintenance costs of physical property are generally reflected in the income component of property indexes and are not considered here.

4

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