Understanding Systematic Risk in Real Estate Markets
52 Pages Posted: 28 Aug 2012
Date Written: September 26, 2011
A one-factor pricing model is employed to investigate the internal consistency of single family home and professionally-managed property prices. The risk factor used here is the US real estate index, which has much stronger explanatory power than the S&P 500 index for real estate assets. Empirical tests with this model lead to several surprising results. First, portfolios of East Coast or West Coast cities have negative risk-adjusted returns (alpha), while a portfolio of all inland cities has positive alpha. Second, a momentum strategy does not outperform the US real estate index on a transaction and risk-adjusted basis, despite its ability to pick the largest-growth cities. Third, high-beta cities have negative alpha, while low-beta cities have positive alpha, even after considering transaction costs. Fourth, high rental yield cities have positive alpha and vice-versa, even after transaction costs. Fifth, large cities have negative alpha, while small cities have positive alpha. Finally, expensive cities have negative alpha and vice-versa. A possible explanation for these abnormal returns is that some cities are systematically neglected by investors.
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