Abstract
The volatility of returns is probably the most widely used risk measure for real estate. This is rather surprising since a number of studies have cast doubts on the view that volatility can capture the manifold risks attached to properties and corresponds to the risk attitude of investors. A central issue in this discussion is the statistical properties of real estate returns—in contrast to neoclassical capital market theory they are mostly non-normal and often unknown, which render many statistical measures useless. Based on a literature review and an analysis of data from Germany we provide evidence that volatility alone is inappropriate for measuring the risk of direct real estate.We use a unique data sample by IPD, which includes the total returns of 939 properties across different usage types (56% office, 20% retail, 8% others and 16% residential properties) from 1996 to 2009, the German IPD Index, and the German Property Index. The analysis of the distributional characteristics shows that German real estate returns in this period were not normally distributed and that a logistic distribution would have been a better fit. This is in line with most of the current literature on this subject and leads to the question which indicators are more appropriate to measure real estate risks. We suggest that a combination of quantitative and qualitative risk measures more adequately captures real estate risks and conforms better with investor attitudes to risk. Furthermore, we present criteria for the purpose of risk classification.
Highlights
Since the development of Modern Portfolio Theory volatility has become the standard measure of risk for any kind of investment
Webb and Pagliari (1995) identified various reasons why volatility as a risk measure for real estate should be seen with some scepticism: the poor quality of the direct real estate data, the cyclicality of real estate returns, high transaction costs, and appraisal-based returns which lead to unrealistic volatility values for direct real estate compared with stocks and bonds
This paper has examined whether volatility is an appropriate measure of risk for direct real estate investments from a theoretical and an empirical perspective
Summary
Since the development of Modern Portfolio Theory volatility has become the standard measure of risk for any kind of investment. Whilst academics are aware that standard deviation is not appropriate for direct real estate many still use the volatility as their measure of risk anyway (see, Cheng and Roulac 2007; Heydenreich 2010; Cheng et al 2010; Kaiser and Clayton 2008; Lee 2003; Lee and Stevenson 2006; Hoesli et al 2004; Pagliari and Scherer 2005; among others). This is not the case for real estate practitioners. It suggest some requirements regarding more appropriate risk measures and offers a classification scheme
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