Is There a Risk Premium Puzzle in Real Estate
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Is There a Risk Premium Puzzle in Real Estate
Is There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estateus.wisc.edu.AbstractThis paper is based on my Presidential Address to the American Real Estate and Urban Economics Association delivered at Washington, D.C., in January 2003. The paper asks whether there is a risk premium puzzle in real estate. The paper examines this question by reporting on an emp Is There a Risk Premium Puzzle in Real Estateirical investigation of real estate investors' expectations over the last fifteen years. The results suggest that ex ante expected risk premiums on reIs There a Risk Premium Puzzle in Real Estate
al estate are quite large for their risk, loo large to be explained by standard economic models. Further, the results suggest that ex ante expected reIs There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estates. The latter conclusion suggests that using historical averages to estimate the risk premium on real estate is misleading.https://khothuvien.cori!IntroductionFor some time, we have known that investors are extremely unwilling to accept variations in stock returns without, on average, earning a high Is There a Risk Premium Puzzle in Real Estate premium (Mehra and Prescott 1985).1 But investors seem much less risk averse when it comes to investing in real estate, at least judging from the hisIs There a Risk Premium Puzzle in Real Estate
torical spread between real estate returns and the return on fixed-income securities over the past quarter century. This raises the questions: Which iIs There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estatehe evidence in the real estate market would seem to imply?This is an important question, but answering it is not easy. For example, it might seem natural to gauge whether investors require a large premium to invest in real estate by looking at the average return earned on real estate over a long per Is There a Risk Premium Puzzle in Real Estateiod of time in the past. Yet there are obvious problems with this approach. First, one needs about half a century' of returns to be confident that theIs There a Risk Premium Puzzle in Real Estate
historical spread on an asset is unconditional mean and not luck (Jorion and Goetzmann 1999). Unfortunately, reliable data on real estate returns in Is There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estate future real interest rates or expected future excess returns on real estate are increasing, ii) the expected future growth in the asset's cash flows is decreasing or iii) some combination of these effects occur simultaneously (Campbell 1991). So, simply using historical averages to estimate the ris Is There a Risk Premium Puzzle in Real Estatek premium on real estate can be misleading.1In this paper risk aversion is analyzed from a different perspective. Using data from a longitudinal surveIs There a Risk Premium Puzzle in Real Estate
y of real estate investors conducted at regular quarterly intervals beginning in 1988,1 offer support for the hypothesis that real estate investors arIs There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estate. Moreover, this ex ante risk premium is more than double that of equities, at least when compared to the estimates of Blanchard (1993). Wadhwani (1999), Claus and Thomas (2000), Fama and Trench (2002) and Jagannathan, McGrattan and Scherbina (2001).1 also find evidence in support of the hypothesis Is There a Risk Premium Puzzle in Real Estatethat real estate investors tend to have uniform expectations. One explanation for this result is the "normal range" hypothesis. This hypothesis assertIs There a Risk Premium Puzzle in Real Estate
s that investors expect future returns to tend toward a "normal level" that can be estimated on the basis of past experiences (Malkiel 1964). An alterIs There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estateat their contrarian behavior will damage their reputations as sensible decision makers (Scharfstein and Stein 1990, Zwiebel 1995). Still others argue that many investors make the same decision, but they do so on the basis of limited information (Conlisk I960. Banerjee 1989 and Bikhchandani, Hirshlei Is There a Risk Premium Puzzle in Real Estateler and Welch 1992).I also look al whether ex ante risk premia vary' across different property types. This is motivated in pan by a desire to know wheIs There a Risk Premium Puzzle in Real Estate
ther ex ante risk premia arc related to observable characteristics. Here a number of interesting cross-sectional patterns can be observed. For exampleIs There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estateain property types perform belter than other property types.2https://khothuvien.cori!The perplexity of this result is compounded by the fact that real estate investors appear to be no more uncertain about expected future returns after a decrease in price and fall in return than after an increase in Is There a Risk Premium Puzzle in Real Estateprice and return.The key result of the paper is that average expected risk premiums on real estate are higher than average realized risk premiums forIs There a Risk Premium Puzzle in Real Estate
the 1988-2002 period, indicating that real estate experienced unexpected capital losses. It is difficult to argue that these losses occur because expeIs There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estate. One would therefore conclude that actual returns on real estate have been lower than expected returns because cash flow growth was lower than expected, or negative. Interestingly enough, Fama and French (2001) present contrasting evidence of a large unanticipated gain on common stocks during the p Is There a Risk Premium Puzzle in Real Estateast half centuty. These two stories imply an increase in demand for stocks relative to real estate during a time period when ex ante expected returnsIs There a Risk Premium Puzzle in Real Estate
on Slocks were falling.Below, I establish these results through some rather simple, but useful, comparisons. More and better data are needed to investIs There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estatele and some summary statistics. In the third section I present the aggregate risk premium estimates. It is there that I show that the ex ante risk premium on real estate is too large to be explained by standard economic models. The fourth section shows that realized returns on real estate over the p Is There a Risk Premium Puzzle in Real Estateeriod 1988-2002 have included large unexpected capital losses. The fifth section3examines the sources of these unexpected capital losses. In the penulIs There a Risk Premium Puzzle in Real Estate
timate section, I study whether actual capital gains for 1988-2002 are far below expected capital gains. This is an alternative way of measuring whethIs There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estatea from the Korpacz survey to focus on investors' expectations. The Korpacz survey is a quarterly survey of real estate investors concerning office, retail, apartment and industrial returns. The Korpacz Organization sponsored the surveys from 1988Q1-1999Q3 and Pricewaterhouse Cooper’s has sponsored t Is There a Risk Premium Puzzle in Real Estatehe surveys since 1999Q3. The sample covers the 1988Q1-2002Q3 period. The survey is conducted through questionnaires mailed to prominent real estate inIs There a Risk Premium Puzzle in Real Estate
vestment market participants in the U.S. The 100-odd participants of the survey are mostly institutional investors (e.g., pension plans, foundations, Is There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estateparticipants to report separately their prospective rates of return (pretax) for office, retail, apartment and industrial buildings in the current quarter. These forecasts are then aggregated to produce an expected return series for the country as a whole for each property type.4The returns data per Is There a Risk Premium Puzzle in Real Estatetain for the most part to institutional investment-grade properties only. This includes CBD and suburban office buildings, major retail properties, urIs There a Risk Premium Puzzle in Real Estate
ban high-rise and garden apartment buildings as well as industrial warehouses which are completed and substantially leased, which are occupied by majoIs There a Risk Premium Puzzle ill Real Estate?James D. Shilling*♦University of Wisconsin. School of Business, Madison, Wisconsin 53706 orjshilling@bu Is There a Risk Premium Puzzle in Real Estate a fairly safe rate of return.The returns are reported at their unlevered rate. The major reason for doing this is the belief that rates of return over time and their relationship with the market are more stable when we can abstract from all changes in leverage and get at the underlying risk of real Is There a Risk Premium Puzzle in Real Estate estate.Figures la-d present histograms of the Korpacz returns from 1988Q1-2002Q3. Several patterns in the Korpacz returns are of interest. The most oIs There a Risk Premium Puzzle in Real Estate
bvious is the skewness in the individual distributions. The evidence suggests that investors only rarely expect discount rates on real estate less thaGọi ngay
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