Trading in the housing market: A model with transaction costs

High predictability of returns on housing suggests pervasive irrationality on the part of market participants. In this paper, we show that with small transactions costs, returns may remain highly predictable even if the market contains substantial numbers of risk neutral, rational speculators. The reason is that option values associated with the transactions costs substantially delay arbitrage transactions. Our model can generate positive short-run and negative long-run autocorrelation in returns on housing similar to those identified by past empirical studies. •Market house prices and fundamental values follow continuous time processes.•Rational investors value their options to either buy or sell a house.•The solution tracks the effect of transactions costs on house prices simply.•Autocorrelation patterns in model returns are similar to empirical studies.•Rational agents may not dominate in the determination of house prices.