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Diverging Values and Fundamentals: A Phase or A Transformation?

Working paper #471
Charles F. Lowrey

The author examines the capital market forces, supply/demand dynamics and demographic changes that have contributed to the apparent disparity between pricing and fundamentals. Theoretically, capital should become more expensive and scarcer as the risk associated with an investment increases. But, recently, just the opposite seems to have occurred in the real estate market. Despite the weaker property market conditions, liquidity abounds, and asset pricing is rich. Although many factors ultimately will determine how long this disconnect persists, capital market forces, property market dynamics and demographic changes provide some explanation for why the disconnect developed and what features, if any, will endure. While the gap between asset pricing and market fundamentals should narrow as the economy and stock market recover, longer-term forces, such as the lower return expectations for all asset classes, more rational and efficient capital allocation and powerful demographic trends, should continue to be positive influences on the pricing for real estate investments. The author concludes that while some features of the current environment are more cyclical than secular, others will be part of the new normalcy in the market, since they are a reflection of long-term fundamental forces.

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