I'm wondering if there is an application of quantitative finance to real estate investment? Specifically I'm wondering about models for pricing small neighborhoods (or even single houses) that take into account things like price, average rent, taxes, interest rates, etc. A preliminary google search showed a few basic models, for example geometric brownian motion. Is there a good reason why quantitative finance methods might not be as useful for real estate pricing?
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$\begingroup$ Perhaps The Journal of Real Estate Finance and Economics would be a good place to look? $\endgroup$– nathanesauJul 7, 2015 at 6:17
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$\begingroup$ There is a large amount of quant research on the behavior of mortgage borrowers, for example on the decision to refinance or not (so called prepayment models). Not sure if you are interested in that or not. $\endgroup$– nbbo2Aug 7, 2015 at 17:35
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1$\begingroup$ Zillow does a lot of this on the back end. Would be interesting to see the models they use. $\endgroup$– RossOct 6, 2015 at 12:44
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2 Answers
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Quant finance is about finding prices of illiquid assets in terms of more liquid assets.
So if you have the the data for liquid small house prices you should be able to come up with a reasonable guess for less liquid larger houses, for example.
That's basically what's been done all the time - replication of complicated derivatives wrt more liquid assets.
I wouldn't worry about brownian motion and think more along the lines of regression for now.
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2$\begingroup$ Quantitative finance encompass more than pricing illiquid assets as evidenced by the diverse questions on this site and many definitions available on the web. $\endgroup$ Oct 6, 2015 at 13:15
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In fact there is at least one application, namely in the pricing of reversions. The simplest case of a reversion is where there is no ground rent, and where exclusive possession (including the right to sell the property, or to rent it out) is deferred to some future date.
Practically, this means foregoing any income from the property until the reversion date. There is some dispute about how to price reversions, and, weirdly, the discount from spot is set by expert witnesses and judges. Google 'Sportelli judgment' for an insight.
Logic suggests that the rate should be determined by the present value of the expected foregone rent. More difficult than it sounds, since 'voids' (periods where property not let) and expected depreciation have to be taken into account. Short term rental is effectively a floating rate that can be reset periodically, with legal permission, whereas a lease (the opposite of a reversion) effectively fixes the long term rental value, analogous to the way that we can fix interest rates.
Note that reversions are settled in cash, rather than deferred settlement, unlike a forward, so everything is present value.
