Security prices and physical stocks of capital are determined jointly in a rational expectations economy as functions of a set of exogenous stochastic factors. Investors employ firm marginal productivity of capital to allocate savings across firms. Firm capital stocks adjust to exogenous shocks across many periods. Security price functions in period t are derived in the cases of constrained and unconstrained firm capital in t. The risk premia in security returns include two sets of terms. One set, corresponding to traditional asset pricing models, relates cash flows directly to the stochastic factors. The second set captures interfirm effects which arise because firm capital in each period t is durable.
Although market-based models of asset valuation have found fruitful application in the securities markets, their implementation has been slow in real estate. One reason for this disparity is the lack of information on real estate asset prices and cash flows. Theoretical applications have been limited as well by an inability to link investors' demands for securities with distributions of cash flows to the underlying physical assets.
Lucas (1978), expanding a methodology developed by LeRoy (1973), provides an asset-pricing model for an exchange economy where cash flows to securities are generated by an exogenous, stationary stochastic process. Brock (1982) extended Lucas' results to a production economy. His work brings one close to the conceptual marriage of asset-pricing models and real estate investment analysis. This paper adapts Brock's analytical framework to real estate by introducing the assumption that physical capital is subject to a stock adjustment constraint.
Section 1 of the paper introduces four sets of agents and defines the behavior of each. Section 2 specifies firm and investor budget constraints. Section 3 defines equilibrium in product and capital markets. Section 4 develops the security pricing relationships.