Factor Analysis for Real Estate

Abstract

The benchmarks for direct investments in real estate are mostly appraisal-based. They are usually smoothed. Therefore they are lagging the "true" returns in the property markets and understate their volatility and their correlation to other asset classes.

The basic idea in our approach is to use data on indirect real estate (REITs), determine their factor exposures to other asset classes and deliver the exposures according to the leverage in the REITs. As an application we use this model for asset allocation.

Our model shows that direct real estate has low interest rate sensitivity (duration of 2 to 7 depending on the country) and high correlation to equities and credit exposure. These properties are important for risk management which is simple to implement in any risk management system using factor exposures.