Do institutional real estate investors have rational expectations? Working Paper

(2001) found evidence that US real estate investors are irrational when they found negative relationship between capitalization rate and rental growth. Shilling (2003) then questioned whether US real estate investors are overly risk averse after observing large deviations between the historical ex-ante and ex-post rates of return in real estate. The two results tend to suggest that investors are not able to respond efficiently to market information, which reject the hypothesis that anticipations are unbiased expectations of actual realizations. We seek to test the rational expectation hypothesis using Campbell-Shiller VAR framework. We separate the forward returns into a rational and irrational components and test their first and second moment relationships with the realized returns. Our results show that irrational expectation of investors has negative effects on the realization of return one period ahead. The innovations in unrealized returns, which are the deviations of expected returns from the realized returns, explain significant share of the variances in realized returns. The results imply that the risk averse behavior of US investors as found by Shilling (2003) does have significant effects on the first and second moments of price changes in real estate