Is Risk of Real Estate Predictable?
44 Pages Posted: 28 Nov 2016 Last revised: 1 Nov 2018
Date Written: October 31, 2018
Previous research finds that the cap rate, that is, the income-price ratio of commercial real estate, predicts future investment returns. This finding’s implication on the efficiency of the real estate market crucially depends on whether the cap rate also predicts future risk. Using accurately measured investment returns of 6,500 commercial properties with total acquisition value of 224 billion dollars from 1982 to 2017, I test whether individual properties’ acquisition cap rates predict future investment risk, after confirming that they predict returns. Using an index of commercial real estate risk premium constructed from the sample, I find that cap rates predict future volatility of the index during properties’ holding periods. Cap rates also predict properties’ non-systematic risk, which is measured with the per-period squared deviation of properties’ risk premium from the average real estate risk premium during holding periods. Finally, I develop and estimate a novel model that allows me to test possible relationships between properties’ cap rates and their future factor loadings, and I find no evidence for such relationships.
Keywords: Real estate, return and risk, predictability, cap rates
JEL Classification: G12, R33
Suggested Citation: Suggested Citation