The investor’s expectation is instinctively to be linked to the asset’s return by the finance experts and analysts. However why and how it affects the return are poorly understood and explained. Can the investor’s expectation really move the market? How much the influence does it have? This study looks at this well-known puzzle between real estate returns and investors’ expectations on rental income growth of real estate assets. Based on the theoretical model in this study, the questions whether, why and how the investors’ expected rental income growth has effects on the real estate returns are answered. The study focuses on both private and public real estate (REITs) returns and examines whether they can be explained by the facts in Hong Kong.

The theoretical model is derived from the Gordon Growth Model. The novelty of the model is to define the term structure of interest rate on the expected rental income. Empirically, the linkage between the two markets is identified through the REIT’s dividend, which is specified to be distributed from 90% of the real estate asset’s income. Under this specification, strong evidence is found for expected rental income growth predictive power. In this study, the relationship between the monthly end-of-period REIT’s return and monthly expected rental income growth of corresponded real estate asset is tested by panel model, which does the superb job in fitting both cross-sectional and time-varied return patterns of REITs. As the REITs in Hong Kong had just launched since the end of year 2005, the sample period of this study is from November, 2005 to April, 2010. Unlike the standard asset pricing model, this study adds the investor’s expectation as one of the factors which determine the REIT’s return to adjust the out-performance tendency of certain asset.

The study also confirms the hypothesis in private real estate market by finding that investors’ expectation on rental growth imposes a positive and significant impact on the real estate return in Hong Kong. The quarterly data series of macro-economic factors, such as Gross Domestic Production, Inflation rate, Interest rate, Employment rate are tested to confirm their effects on the real estate return together with the investor’s expectations on both future rental income and inflation. All four real estate sectors, including residential, office, retail and industrial property sectors, are inclusively tested in this study.

For both private and public real estate markets in Hong Kong, the investor’s expectation has positive effects on the corresponding asset’s return. The evidence in this study shows that the change of investor’s expectation would cause positive change of REIT’s return. It reveals that the investors’ expectation plays a vital role in the movement of both private and public real estate markets. When most investors expect a tendency of increasing earning, the real estate return tends to rise with controlling of other economic factors. 

Though the conclusion of this study is well-known and frequently used to explain or predict the movement of real estate market, the theory behind it is commonly ignored. This study looks deeper into it by improving Gordon Growth Model to capture the investor’s expected rental income growth without econometric forecasting or questionnaire investigation. The series derived in this study is more reliable with clear logic and theory, and confirmed by the facts in Hong Kong real estate market. The derivation and application of the investor’s expected income growth of certain asset will be helpful to provide insightful implications on future asset pricing, finance prediction and analysis.