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.