Market Risk of Real Estate

Abstract:     
Direct real estate is the largest asset class without readily available prices. The market capitalization is comparable to that of equities and fixed income, and much larger than that of other alternative asset classes like private equity or hedge funds. Nevertheless, because of the missing price information, it is difficult to estimate the market risk of direct real estate. We propose a simple methodology that uses data on indirect real estate to provide a better understanding of the real estate market risk. Our model uses widely available data and solves the problems posed by the appraisal and transaction-based indices, as well as by the hedonic approach, which are difficult to implement in practice. In particular, we use data on Real Estate Investment Trusts (REITs) returns, determine their factor exposures to other asset classes, and delever these exposures according to REITs’ balance sheets. We find that the existing direct indices understate real estate market risk. Indeed, using data from the UK, the volatility of the real estate asset class that our model entails is almost three times that of appraisal-based indices, and two times that of transaction-based ones. In addition, the correlations to other asset classes are materially different and higher, which is important in a portfolio context. We argue that these findings can have important empirical implications, as they can be useful for practitioners aiming at achieving a simple, transparent and more accurate risk management of their portfolios. Moreover, our findings can help to better understand extreme risks in the real estate market, which have a high impact on the overall economy, as was observed in the recent financial crisis.

Keywords: public and private real estate, real estate risk, mixed-asset diversification

JEL Classification: G11, G23, R33, C32

working papers series