Liquidity and Information Asymmetry in the Real Estate Market

George Akerlof??s asymmetric information theory explains why lemons are rarely, if at all, transacted. We extend his theory to explain liquidity in the second-hand real estate market. The idea is to decompose real estate into two components: land and the building structure. While sellers may know more about the quality of their structures than buyers, information on land, predominantly its locational attributes, is much more transparent. Without assuming any credit constraints or loss aversion behaviour, our information asymmetry model shows that: 1) the liquidity of real estate increases with the share of its land value; 2) there is a positive relationship between real estate prices and turnover rates when land supply is more inelastic than the supply of structures; 3) the positive relationship is stronger when the land value component gets smaller; and 4) while the availability of first-hand real estate may divert demand away from the second-hand market, such a substitution effect is weaker when the land value component is large. These four implications were confirmed with panel data analysis using Hong Kong??s housing transactions from 1992 to 2008 across 50 districts.