Purpose
The purpose of this paper is to develop benchmarking standards for risk premiums in capitalization rates and commercial mortgage rates, to examine the impact of investor choice of property type and geographic markets on those risk premiums, and to supplement the quantitative analysis with historical and behavioral decision-making factors.
Design/methodology/approach
Using data sets extending from 1Q 1995 to 2Q 2016, a range of risk premiums is calculated and norms established at the 65th and 35th percentiles by property type and investment position. Relative levels of the risk premiums are compared to three defined categories of urban markets, to discover potential risks in yield-seeking market selection. A historical context is discussed to illustrate that prudential judgment is needed to supplement statistical measures of risk.
Findings
A stable range of risk premiums is identified for the pre-financial crisis period 1995-2003, the dislocations of risk pricing 2004-2007 leads to an extreme reaction 2009-2012. A period of “renormalization” is hypothesized thereafter. An important distinction is made between the transaction peak of 2007, and the numerically similar peak of 2015. Taxonomy of urban property markets is adduced.
Practical implications
Investment analyses and portfolio allocation decisions can benefit from a longitudinal examination of risk premiums hitherto unavailable. The proposed taxonomy of markets has been shown (elsewhere) to correlate to investment performance. City planners may wish to capture increased real estate value stemming from investor preferences among cities.
Originality/value
The risk premium benchmarking is not previously available in the scholarly literature. The historical context as a prudential element in evaluating risk is not often emphasized in the finance literature.
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