Pricing risk and its use in modelling real estate market yields

Abstract

Purpose In the light of past financial and economic turmoil, there has been a marked increase in the volatility in real estate markets. This has impacted on the pricing of property assets, partly through market sentiment and particularly concerning risk. It also limits modelling accuracy model accuracy. The purpose of this paper is to create a new variable and model to enhance analysis of what drives real estate yields incorporating market sentiment to risk. Design/methodology/approach This paper specifically considers the modelling of property pricing within a volatile economic environment. The theoretical context begins by analysing the relationship between property yields and government bonds. The analytical context then moves on to specifically include a measurement of risk which stresses its role and importance in investment markets since the Global Financial Crisis. The model thus incorporates macroeconomic and real estate data, together with an international risk multiplier, which is calculated within the paper. Findings The paper finds the use of measurements of market sentiment and risk are more powerful tools for modelling yields than previous techniques alone. Research limitations/implications This is an initial paper outlining the creation of sentiment and risk measurements in the financial market and showing an example of its application to a commercial real estate market. The implication is that this could add a major new explanatory variable to modelling of yields. Practical implications The paper highlights the importance of risk in the pricing of commercial real estate, over and above normal variables. It highlights how this can help explain over and undershooting of yields within commercial real estate which would be of great importance in the investment world. Originality/value This paper attempts to explicitly measure market sentiment, pricing of risk and how this impacts real estate pricing.

Yield rate in the Warsaw office market and its determinants. Further studies

“…At macro-financial level, a risk premium in the commercial real estate market can be imputed as the term structure of interest rate, monetary policy, and capital flows both at international and national level (Szweizer 2019), interdependencies to the risk premium of investment in stocks and bonds (interest/rate of return spread) and their cyclicality (McGough and Berry 2020;Liow 2016). It also can be assigned to characteristics of the country/commercial real estate market specific risk such as national economic prosperity, i.e.…”

Capitalisation rates for commercial real estate investments: evidence from Australia

“…It incorporates the cash flow generating ability of the specific asset, making it intuitive and insightful to investors in determining the return on investment while movements in the underlying capital asset value capture the risk associated with the specific asset. However, quantitative modelling of the capitalisation rate has remained challenging because conceptualising a model for evaluating real estate risk factors is non-existent in the literature (McGough and Berry, 2020). Existing studies usually examine the role of macroeconomic variables and fundamental drivers such as GDP growth, rental growth and bond yields (Sivitanidou and Sivitanides, 1999).…”

“…Despite the scarcity of research on cap rates, the few studies that have focussed on its determinants have considered micro-and macroeconomic factors and have generally concentrated on US cities (see, for example, Chuangdumrongsomsuk and Fuerst, 2017;Sivitanides et al, 2001;Sivitanidou and Sivitanides, 1999) and Europe (Lee, 2009(Lee, , 2012(Lee, , 2017McAllister and Lizieri, 2006;McGough and Berry, 2020;McGough et al, 2000;Oikarinen and Falkenbach, 2017). However, as previously noted, there is a distinct lack of comparable studies regarding cap rate determinants in the Australian commercial property market.…”