Coherent risk measures in real estate investment
Abstract
Purpose
The purpose of this paper is to propose a new way to measure risk in real estate investment, which departs from traditional statistical methodology borrowed from finance.
Design/methodology/approach
An argument is advanced for the use of so‐called coherent risk measures for real estate investment decisions. Central to this class of measure is the computation of spectral risk, a measure that covers the spectrum of an individual's risk aversion function. Intuition being hard to observe, empirical data from two large databases are presented as support.
Findings
At the heart of the controversy is a discussion of the nature of risk and how it should be measured. This paper seeks common ground where peace may be made between these two warring factions. Scenarios are tested wherein different risk aversion functions are used to compute spectral risk for different sectors. Ex‐post analysis shows that reasoning of this nature can lead to improved risk‐adjusted investment results.
Practical implications
The route to finding an appropriate risk measure for real estate investment has been tortuous. It is not certain that the destination has been reached. Complicating the task is a considerable gap between academic and practitioner methodology, the former relying on the mathematics of objective probability, the latter dwelling quite successfully in a habitat of subjective risk measures.
Social implications
It is widely accepted that risk represents a cost to society. Real estate, as a repository of roughly half the world's wealth, can be viewed as having risk of a structurally different nature. The better understanding of this risk reduces the cost to society.
Originality/value
For practitioners, spectral measures offer formal support for something they have been doing their entire careers: evaluating risk subjectively. The simple dot product of weights and ordered outcomes is an extension of the widely used “Best case – Worse case – Most likely” methodology that has served professionals well for decades. Perhaps a by‐product of spectral measures is to bring academics and field gladiators closer together. If there is merit to a new way of thinking about risk independent of its implementation, real estate investment could benefit from that thinking. Among those who doubt that everything is “normal” are those who believe that previous attempts to explain risk in real estate have fallen far short of the mark. The challenge to those still not satisfied by the spectral approach is to offer an alternative that represents both a departure from and an improvement of the old methods.
Keywords
Citation
Brown, R. and Young, M. (2011), "Coherent risk measures in real estate investment", Journal of Property Investment & Finance, Vol. 29 No. 4/5, pp. 479-493. https://doi.org/10.1108/14635781111150358
Publisher
:Emerald Group Publishing Limited
Copyright © 2011, Emerald Group Publishing Limited