Systematic property risk: quantifying UK property betas 1983-2005

The increased frequency in reporting UK property performance figures, coupled with the acceptance of the IPD database as the market standard, has enabled property to be analysed on a comparable level with other more frequently traded assets. The most widely utilised theory for pricing financial assets, the Capital Asset Pricing Model (CAPM), gives market (systematic) risk, beta, centre stage. This paper seeks to measure the level of systematic risk (beta) across various property types, market conditions and investment holding periods. This paper extends the authors’ previous work on investment holding periods and how excess returns (alpha) relate to those holding periods. We draw on the uniquely constructed IPD/Gerald Eve transactions database, containing over 20,000 properties over the period 1983-2005. This research allows us to confirm our initial findings that properties held over longer periods perform in line with overall market performance. One implication of this is that over the long-term performance may be no different from an index tracking approach.

Aligning asset allocation and real estate investment: some lessons from the last cycle

Asset allocation is concerned with the development of multi--‐asset portfolio strategies that are likely to meet an investor’s objectives based on the interaction of expected returns, risk, correlation and implementation from a range of distinct asset classes or beta sources. Challenges associated with the discipline are often particularly significant in private markets. Specifically, composition differences between the ‘index’ or ‘benchmark’ universe and the investible universe mean that there can often be substantial and meaningful deviations between the investment characteristics implied in asset allocation decisions and those delivered by investment teams. For example, while allocation decisions are often based on relatively low--‐risk diversified real estate ‘equity’ exposure, implementation decisions frequently include exposure to higher risk forms of the asset class as well as investments in debt based instruments. These differences can have a meaningful impact on the contribution of the asset class to the overall portfolio and, therefore, lead to a potential misalignment between asset allocation decisions and implementation. Despite this, the key conclusion from this paper is not that real estate investors should become slaves to a narrowly defined mandate based on IPD / NCREIF or other forms of benchmark replication. The discussion suggests that such an approach would likely lead to the underutilization of real estate in multi--‐asset portfolio strategies. Instead, it is that to achieve asset allocation alignment, real estate exposure should be divided into multiple pools representing distinct forms of the asset class. In addition, the paper suggests that associated investment guidelines and processes should be collaborative and reflect the portfolio wide asset allocation objectives of each pool. Further, where appropriate they should specifically target potential for ‘additional’ beta or, more marginally, ‘alpha’.

The value premium and time-varying volatility

Numerous studies have documented the failure of the static and conditional capital asset pricing models to explain the difference in returns between value and growth stocks. This paper examines the post-1963 value premium by employing a model that captures the time-varying total risk of the value-minus-growth portfolios. Our results show that the time-series of value premia is strongly and positively correlated with its volatility. This conclusion is robust to the criterion used to sort stocks into value and growth portfolios and to the country under review (the US and the UK). Our paper is consistent with evidence on the possible role of idiosyncratic risk in explaining equity returns, and also with a separate strand of literature concerning the relative lack of reversibility of value firms' investment decisions.

Speculative bubbles and the cross-sectional variation in stock returns

Evidence suggests that rational, periodically collapsing speculative bubbles may be pervasive in stock markets globally, but there is no research that considers them at the individual stock level. In this study we develop and test an empirical asset pricing model that allows for speculative bubbles to affect stock returns. We show that stocks incorporating larger bubbles yield higher returns. The bubble deviation, at the stock level as opposed to the industry or market level, is a priced source of risk that is separate from the standard market risk, size and value factors. We demonstrate that much of the common variation in stock returns that can be attributable to market risk is due to the co-movement of bubbles rather than being driven by fundamentals.

Analytic approximations for multi-asset option pricing

We derive general analytic approximations for pricing European basket and rainbow options on N assets. The key idea is to express the option’s price as a sum of prices of various compound exchange options, each with different pairs of subordinate multi- or single-asset options. The underlying asset prices are assumed to follow lognormal processes, although our results can be extended to certain other price processes for the underlying. For some multi-asset options a strong condition holds, whereby each compound exchange option is equivalent to a standard single-asset option under a modified measure, and in such cases an almost exact analytic price exists. More generally, approximate analytic prices for multi-asset options are derived using a weak lognormality condition, where the approximation stems from making constant volatility assumptions on the price processes that drive the prices of the subordinate basket options. The analytic formulae for multi-asset option prices, and their Greeks, are defined in a recursive framework. For instance, the option delta is defined in terms of the delta relative to subordinate multi-asset options, and the deltas of these subordinate options with respect to the underlying assets. Simulations test the accuracy of our approximations, given some assumed values for the asset volatilities and correlations. Finally, a calibration algorithm is proposed and illustrated.

Pricing inefficiencies in private real estate markets using total return swaps

Efficient markets should guarantee the existence of zero spreads for total return swaps. However, real estate markets have recorded values that are significantly different from zero in both directions. Possible explanations might suggest non-rational behaviour by inexperienced market players or unusual features of the underlying asset market. We find that institutional characteristics in the underlying market lead to market inefficiencies and, hence, to the creation of a rational trading window with upper and lower bounds within which transactions do not offer arbitrage opportunities. Given the existence of this rational trading window, we also argue that the observed spreads can substantially be explained by trading imbalances due to the limited liquidity of a newly formed market and/or to the effect of market sentiment, complementing explanations based on the lag between underlying market returns and index returns.

Rational expectations? Developer behaviour and development cycles in the central London office market

Purpose – Expectations of future market conditions are acknowledged to be crucial for the development decision and hence for shaping the built environment. The purpose of this paper is to study the central London office market from 1987 to 2009 and test for evidence of rational, adaptive and naive expectations. Design/methodology/approach – Two parallel approaches are applied to test for either rational or adaptive/naive expectations: vector auto-regressive (VAR) approach with Granger causality tests and recursive OLS regression with one-step forecasts. Findings – Applying VAR models and a recursive OLS regression with one-step forecasts, the authors do not find evidence of adaptive and naïve expectations of developers. Although the magnitude of the errors and the length of time lags between market signal and construction starts vary over time and development cycles, the results confirm that developer decisions are explained, to a large extent, by contemporaneous and historic conditions in both the City and the West End, but this is more likely to stem from the lengthy design, financing and planning permission processes rather than adaptive or naive expectations. Research limitations/implications – More generally, the results of this study suggest that real estate cycles are largely generated endogenously rather than being the result of large demand shocks and/or irrational behaviour. Practical implications – Developers may be able to generate excess profits by exploiting market inefficiencies but this may be hindered in practice by the long periods necessary for planning and construction of the asset. Originality/value – This paper focuses the scholarly debate of real estate cycles on the role of expectations. It is also one of very few spatially disaggregate studies of the subject matter.

The dynamics of asset prices and transaction activity in illiquid markets: the case of private commercial real estate

This paper investigates the relationship between capital flows, turnover and returns for the UK private real estate market. We examine a number of possible implication of capital flows and turnover on capital returns testing for evidence of a price pressure effect, ‘return chasing’ behaviour and information revelation. The main tool of analysis is a panel vector autoregressive (VAR) regression model in which institutional capital flows, turnover and returns are specified as endogenous variables in a two equation system in which we also control for macro-economic variables. Data on flows, turnover and returns are obtained for the 10 market segments covering the main UK commercial real estate sectors. Our results do not support the widely-held belief among practitioners that capital flows have a ‘price pressure’ effect. Although there is some evidence of return chasing behaviour, the short timescales involved suggest this finding may be due to delayed recording of flows relative to returns given the difficulties of market entry. We find a significant positive relationship between lagged turnover and contemporaneous capital returns, suggesting that asset turnover provides pricing information.

Sources of alpha and beta in property funds

This paper examines issues related to potential analytical performance systems for global property funds. These will include traditional attribution methods but will also cover the performance concepts of alpha and beta widely used in other asset classes. We look at issues including...what creates beta, and what drives alpha in real estate investment? How can it be measured and isolated? How do these concepts relate to traditional attribution systems? Can performance records and performance fees adequately distinguish between these drivers? In this paper we illustrate these issues by reference to a case study addressing the complete performance record of a single unlisted fund.

Correlation shifts and real estate portfolio management

The success of any diversification strategy depends upon the quality of the estimated correlation between assets. It is well known, however, that there is a tendency for the average correlation among assets to increase when the market falls and vice-versa. Thus, assuming that the correlation between assets is a constant over time seems unrealistic. Nonetheless, these changes in the correlation structure as a consequence of changes in the market’s return suggests that correlation shifts can be modelled as a function of the market return. This is the idea behind the model of Spurgin et al (2000), which models the beta or systematic risk, of the asset as a function of the returns in the market. This is an approach that offers particular attractions to fund managers as it suggest ways by which they can adjust their portfolios to benefit from changes in overall market conditions. In this paper the Spurgin et al (2000) model is applied to 31 real estate market segments in the UK using monthly data over the period 1987:1 to 2000:12. The results show that a number of market segments display significant negative correlation shifts, while others show significantly positive correlation shifts. Using this information fund managers can make strategic and tactical portfolio allocation decisions based on expectations of market volatility alone and so help them achieve greater portfolio performance overall and especially during different phases of the real estate cycle.