Housing Quality in the Forward Contracts Market

Developers often conduct forward sales (or presales) before building completion to relieve financial risk and burden. However, there are worries that housing units sold in this way will turn out to be substandard because developers, who have been paid for the unfinished units, may have incentives to cut costs by lowering the quality. This is a typical moral hazard problem. Nonetheless, forward sales have been very popular in some Asian cities such as Hong Kong, Singapore, and Taiwan. A plausible explanation is that the market has efficiently adjusted the forward price for this potential quality problem according to developers’ reputations. This paper aims to theoretically explain and empirically test (1) whether reputation is reflected in forward prices and (2) whether the expected quality level matches with the actual quality level. Using the forward and spot sales data of the Hong Kong real estate market, we found that even though housing quality was not observable during presales, the market was able to capitalize developers’ reputations into forward prices accurately. This suggests that the optimal strategy for developers is to stick to the quality level implied by their reputations. A paper submitted to Journal of Real Estate Finance and Economics. A Special Issue for the 2005 NUS-HKU Symposium on Real Estate Research.