A Theory of Liquidity in Residential Real Estate Markets

A “hot” real estate market is one where prices are rising, average selling times are short, and the volume of transactions is higher than the norm. “Cold” markets have the opposite characteristics: prices are falling, liquidity is poor, and volume is low. This paper provides a theory to match these observed correlations. I show that liquidity can be good while prices are high because the opportunity cost of failing to complete a transaction is high for both buyers and sellers. I also show how state-varying liquidity depends on the absence of smoothly functioning rental markets.