Real Estate Returns and Risk with Heterogeneous Investors

Abstract

This article develops a theoretical framework and formulates a unified risk metric that integrates both real estate price risk and uncertainty of time on market (TOM). We demonstrate that real estate sellers with different degrees of financial distress face not only different marketing period risks, but also receive different return distributions upon successful sales. The major findings of this article can be summarized as follows. First, we show that real estate return and risk, which account for both price and TOM risk, are investor specific, varying over investors with different financial circumstances and holding periods. Second, the traditional valuation of real estate return and risk, which is based solely on the return distribution of a successful sale without considering the uncertainty of TOM and the investor's financial circumstances, underestimates real estate risk and exaggerates real estate return. Third, our empirical applications in both residential and commercial real estate markets show that the Sharpe ratio estimated by the traditional approach is seriously overstated-to the largest extent for investors with high financial distress. In addition, we find that, given the typical 5- to 7-year holding period for real estate, the Sharpe ratios estimated by integrating both price and TOM risk are much in line with the performance of financial assets. These findings can help to explain the apparent "risk-premium puzzle" in real estate. Copyright 2008 American Real Estate and Urban Economics Association

The Real Estate Risk Premium Puzzle: A Solution

“…Instead, the NCREIF line is rather much closer to the alternative risk structure proposed by Lin and Liu (2008). This pattern is quite similar to the empirical findings of Lin and Liu (2008) which uses the OFHEO residential property data. Second, the standardized risk of NCREIF closely resembles a straight-line.…”

“…In this section, we first verify the finding of Lin and Liu (2008) with the NCREIF Property Index. We show that their finding, though much more reasonable than the i.i.d.…”

“…, where 1 σ σ = representing the risk of investing for a single-period 7 ) as well as the alternative risk structure derived by Lin and Liu (2008). (1,1) Alternative risk structure:…”

Home Price, Time-on-Market, and Seller Heterogeneity Under Changing Market Conditions

“…The fact that most sellers are found in between these two extremes, with different degrees of constraint, is not considered in their model. This fact is formally incorporated in a recent study by Lin and Liu (2008), in which they develop a theoretical model and formulate a unified risk metric for integrating real estate price risk and marketing period risk. Their model includes an explicit parameter capturing the degree of seller constraint under certain market conditions.…”

Do Credit Constraints Amplify Macroeconomic Fluctuations?

“…The adjustment methods of Quart andQuigley (1989, 1991) are used to be consistent with the volatility measure provided by Lin and Liu (2008). Source: BLS.…”