The Real Estate Risk Premium Puzzle: A Solution

Abstract

For decades, performance comparisons between real estate and financial assets have repeatedly indicated that private real estate investment exhibits significantly higher risk-adjusted returns than publicly traded financial assets such as common stocks. That is, there is an apparent “real estate risk premium puzzle.” In this paper, we find that the seemingly superior risk-adjusted returns of real estate may be caused by inappropriate adoption of the conventional risk measure to real estate, a measure that completely ignores the non-i.i.d. nature of the asset’s return distribution, as well as its illiquidity risk. We develop a modified performance measure—a Sharpe ratio for real estate—to capture the time-dependent nature of real estate risk by incorporating illiquidity risk in a closed-form formula. Our finding shows that, once the real estate risk is properly measured, the longstanding “real estate risk premium puzzle” no longer exists. Our approach also shows that real estate price risk over time can be accurately obtained through empirical estimation without relying on a simplification assumption of a particular distribution like the i.i.d. assumption.