APA Format.Two Pages Summery Of this Artical
An assessment of the risk and return of residential real estate by Dale Domian, Rob Wolf, Hsiao-Fen Yang Format: Article Publication year: 2015 | Peer-reviewed | No other editions or formats Journal: · Managerial Finance v41 n6 (20150608): 591-599 – The home is a substantial investment for most individual investors but the assessment of risk and return of residential real estate has not been well explored yet. The existing real estate pricing literature using a CAPM-based model generally suggests very low risk and unexplained excess returns. However, many academics suggest the residential real estate market is unique and standard asset pricing models may not fully capture the risk associated with the housing market. The purpose of this paper is to extend the asset pricing literature on residential real estate by providing improved CAPM estimates of risk and required return. – The improvements include the use of a levered β which captures the leverage risk and Lin and Vandell (2007) Time on Market risk premium which captures the additional liquidity risk of residential real estate. – In addition to presenting palatable risk and return estimates for a national real estate index, the results of this paper suggest the risk and return characteristics of multiple cities tracked by the Case Shiller Home Price Index are distinct. – The results show higher estimates of risk and required return levels than previous research, which is more consistent with the academic expectation that housing performs between stocks and bonds. In contrast to most previous studies, the authors find residential real estate underperforms based on risk, using standard financial models. – The home is a substantial investment for most individual investors but the assessment of risk and return of residential real estate has not been well explored yet. The existing real estate pricing literature using a CAPM-based model generally suggests very low risk and unexplained excess returns. However, many academics suggest the residential real estate market is unique and standard asset pricing models may not fully capture the risk associated with the housing market. The purpose of this paper is to extend the asset pricing literature on residential real estate by providing improved CAPM estimates of risk and required return. – The improvements include the use of a levered β which captures the leverage risk and Lin and Vandell (2007) Time on Market risk premium which captures the additional liquidity risk of residential real estate. – In addition to presenting palatable risk and return estimates for a national real estate index, the results of this paper suggest the risk and return characteristics of multiple cities tracked by the Case Shiller Home Price Index are distinct. – The results show higher estimates of risk and required return levels than previous research, which is more consistent with the academic expectation that housing performs between stocks and bonds. In contrast to most previous studies, the authors find residential real estate underperforms based on risk, using standard financial models. Read Less An assessment of the risk and return of residential real estate Dale Domian School of Administrative Studies, York University, Toronto, Canada, and Rob Wolf and Hsiao-Fen Yang Department Finance, University of Wisconsin at La Crosse, La Crosse, Wisconsin, USA Abstract Purpose – The home is a substantial investment for most individual investors but the assessment of risk and return of residential real estate has not been well explored yet. The existing real estate pricing literature using a CAPM-based model generally suggests very low risk and unexplained excess returns. However, many academics suggest the residential real estate market is unique and standard asset pricing models may not fully capture the risk associated with the housing market. The purpose of this paper is to extend the asset pricing literature on residential real estate by providing improved CAPM estimates of risk and required return. Design/methodology/approach – The improvements include the use of a levered β which captures the leverage risk and Lin and Vandell (2007) Time on Market risk premium which captures the additional liquidity risk of residential real estate. Findings – In addition to presenting palatable risk and return estimates for a national real estate index, the results of this paper suggest the risk and return characteristics of multiple cities tracked by the Case Shiller Home Price Index are distinct. Originality/value – The results show higher estimates of risk and required return levels than previous research, which is more consistent with the academic expectation that housing performs between stocks and bonds. In contrast to most previous studies, the authors find residential real estate underperforms based on risk, using standard financial models. Keywords Housing, Asset pricing, Real estate Paper type Research paper I. Introduction Residential real estate is perhaps the most commonly held investment asset in the world. Practitioners and some academic research suggest residential real estate has high returns with low risk[1]. Nevertheless, due to the unique characteristics of residential real estate, many authors (e.g. Francis and Ibbotson, 2009) argue the risk of residential real estate investment is higher than often suggested. The recent fallout of the housing market supports the latter view. Regardless, improved understanding of residential real estate performance is long overdue. Goetzman (1993) uses a mean-variance framework to estimate the effects of including a single family home in an investment portfolio. The results suggest home ownership reduces portfolio risk and diversified real estate ownership adds further risk reduction suggesting real estate portfolios are comparatively stable investments. Flavin and Yamashita (2002) use a mean-variance analysis to determine the impact of home ownership on asset allocation. They argue home ownership has life-cycle implications, as young homeowners are burdened with high mortgage debt and must balance their risk with increased ownership in bonds, while older homeowners have less home ownership debt and can benefit from increased equity ownership. Also, Waggle and Johnson (2003, 2009) use a mean-variance utility function to estimate the Managerial Finance Vol. 41 No. 6, 2015 pp. 591-599 ©Emerald Group Publishing Limited 0307-4358 DOI 10.1108/MF-07-2013-0195 Received 25 July 2013 Revised 2 July 2014 24 December 2014 Accepted 4 January 2015 The current issue and full text archive of this journal is available on Emerald Insight at: www.emeraldinsight.com/0307-4358.htm 591 Return of residential real estate impact of the home ownership decision on optimal asset allocation. They find most investors should have a higher allocation of risky stock, when including the impact of home ownership. Assessing the impact of home ownership on a scenario analysis of portfolio performance is useful, however it is also important to price asset risk and return with some theoretically based models. CAPM is the standard asset pricing model for financial assets, but the unique market characteristics of residential real estate such as low liquidity, high leverage, high information asymmetry, etc., suggest the traditional CAPM which assumes the market is perfect and complete may not fully capture the risks in the residential real estate market (See footnote 1). How to adjust the one-factor CAPM model to the unique characteristics of the residential real estate market is an issue of interest to academe and to practitioners. This research presents a CAPM-based asset pricing model with improved assessment of asset risk. Specifically, we incorporate two important risks, associated with the housing investment, into the traditional CAPM: liquidity risk and leverage risk. Due to the heterogeneity of housing assets, the residential real estate market is very illiquid. Investors incur additional costs, including transaction costs, search costs, financing costs, and maintenance costs, when their houses cannot be sold quickly. The liquidity risk taken by housing investors is not trivial. In this paper, we consider the liquidity risk explicitly and use Lin and Vandell’s (2007) Time on Market (TOM) multiplier to proxy for the liquidity risk. Also included is a premium to proxy for the higher leverage of home ownership. Residential real estate is usually the largest investment in a household. To finance the initial investment, most families borrow a substantial percent of the home value. The high leverage magnifies the risk of the investment and increases the possibility of foreclosure during an economic downturn. To capture the increased risk, we use a levered β to estimate the systematic risk and the required housing return. Our results show that both liquidity and leverage risk premiums capture unique risks associated with residential real estate. The result is to increase the estimated risk measures including standard deviation, β and required return. The paper proceeds with a literature review in Section II, a review of the model, data and results in section III, and the conclusions presented in Section IV. II. Literature review The literature has taken at least two distinct approaches to developing an asset pricing model for real estate. The first approach is CAPM (Sharpe 1964; Lintner 1965), the standard asset pricing model. Due to its strong theoretical, intuitive, and practical considerations, CAPM is the most commonly used model in the industry. Using portfolio theory or CAPM, Geltner (1989), Cascio and Clutter (2008), MacKinnon (2008), Francis and Ibbotson (2009), and Cotter and Roll (2009) suggest, that compared to equity investments, residential real estate has often provided high levered returns with low risk and low correlation to the market. Cotter and Roll (2009) find the risk of REITs less than that of equity markets. MacKinnon (2008) finds residential real estate to have the fourth highest Sharpe ratio of twelve asset classes. Consistent with Goetzman (1993), MacKinnon concludes housing’s contribution to an investment portfolio is more risk reduction than return maximization. Francis and Ibbotson (2009) find the average real estate investor accumulates wealth slowly with the additional benefits of high leverage, tax deductibility of interest and valuable diversification opportunities. 592 MF 41,6 In addition to the one-factor CAPM, numerous multifactor models have been developed for real estate, often justified by the Fama and French (1993) three factor model. In contrast to Fama and French, the multifactor models for real estate are designed for and use factors specific to the real estate industry. Cannon et al. (2006) develop an asset pricing model for the housing market from 1996 to 2003 finding a positive relationship between asset volatility and return as well as finding stock market risk priced directionally in the housing market. Beracha and Skiba (2011) develop a cross-sectional pricing model for housing returns including the factors for the US real estate market, the local market income growth, land supply elasticity, and a momentum factor. Over the 25 year sample period, the model factors provide economically significant explanations of housing market returns that are robust over various market segmentations. Case et al. (2011) develop a multifactor asset pricing model for housing including a real estate market factor, an idiosyncratic risk factor, a momentum factor, and a MSA size effects factor. Their model is robust after controlling for socioeconomic variables. They find the market factor significant suggesting a clear risk and return framework for housing returns using real estate systematic risk. Additionally, they find the model robust over different MSAs, but with varying significance. However, Pai and Geltner (2007) develop a three factor model, similar to the Fama