Idiosyncratic Risk and the Cross-Section of European Real Estate Stock Returns

Abstract

This study examines the role of idiosyncratic risk in the pricing of European real estate equities. The capital asset pricing model predicts that in equilibrium investors should hold the market portfolio. As a result, investors should only be rewarded for carrying undiversifiable systematic risk and not for diversifiable idiosyncratic risk. This study is adding to the growing body of countering studies by examining the relationship in both an unconditional and a conditional framework. While size and book-to-market equity are unconditionally related to real estate equity returns, realised and expected idiosyncratic volatility are not priced. However, analysing the relationship between idiosyncratic risk and real estate equity returns in the conditional setting discloses the positive pricing in up-markets and negative pricing in down-markets of both idiosyncratic risk measures. The results are robust to i.) different time periods, ii.) return currency, iii.) return weighting, iv.) country effects, and v.) the measure of expected idiosyncratic volatility.