How does investor sentiment predict the future real estate returns of residential property in Hong Kong

Abstract Given the high volatility of housing prices in Hong Kong and the cycles of boom and bust, the traditional finance theory may not fully explain the market behavior. We observe that there exists a strong gap on explaining the actual interaction between the fundamental economic factors and the property price levels in Hong Kong, resulting in a wrong expectation about the property price levels and trends in various cycles in the past few decades. We therefore construct a proprietary new measure of investor sentiment for the Hong Kong property market to investigate whether sentiment affects residential property prices in Hong Kong. The results confirm that sentiment is negatively related to future returns of Hong Kong residential properties, with a lagged effect from 3 to 12 months. Consistent with the theoretical prediction by previous studies that sentiment should have stronger effect on more speculative assets (i.e. “hard to value” assets), we find that sentiment has a stronger effect on the prices of smaller units in Kowloon district than on larger units in all three Hong Kong districts (Hong Kong Island, Kowloon and New Territories). This study offers important implications for the Government and policy makers to consider timely measures trying to cool down the property market whenever the investor sentiment is persistently high for some period so as to avoid significant price corrections in the future.