Asset Pricing

The following sections are included:

• List of Contributors

• Contents

The following sections are included:

• Time-varying Risk Premium of Real Estate

• Short-term Price Behavior in Real Estate Securities Market

• How Real Estate Market Affects Financial Institutions

• Analysis of Emerging Real Estate Market

• Summary

• References

Recent evidence suggests that the variation in the expected excess returns is predictable and arises from changes in business conditions. Using a multi-factor, latent-variable model with time-varying risk premiums, we decompose excess returns into expected and unexpected excess returns to examine what determines movements in expected excess asset returns and to what extent asset returns move together. We find that expected excess returns for Equity Real Estate Investment Trusts (EREITs) are more predictable than all other assets examined, owing in part to cap rates which contain useful information about the general risk condition in the economy. We also find that the conditional risk premiums (expected excess returns) on EREITs move very closely with those of small cap stocks and much less with those of bonds.

Recent evidence suggests that all asset returns are predictable to some extent with excess returns on real estate relatively easier to forecast. This raises the issue of whether we can successfully exploit this level of predictability using various market timing strategies to realize superior performance over a buy-and-hold strategy. We find that the level of predictability associated with real estate leads to moderate success in market timing, although this is not necessarily so for the other asset classes examined in general. Besides, real estate stocks typically have higher trading profits and higher mean risk-adjusted excess returns when compared to small stocks as well as large stocks and bonds, even though most real estate stocks are small stocks.

Previous studies have found that the return behavior on Japanese assets is consistent with the existing evidence on U.S. stocks in general. The current study offers new insights which suggest that Japanese equity and real estate markets might not necessarily behave in a parallel manner to U.S. capital markets. These insights are obtained from an examination of the nature of expected and unexpected movements in the returns of Japanese assets and U.S. assets, using a present value model which allows for a time-varying expected discount rate in conjunction with a Vector Autoregressive (VAR) process. One distinct difference is that changes in the future expected return for Japanese real estate and stocks are less persistent over time than their U.S. counterparts, even though returns on Japanese real estate (stock) is relatively more predictable than (similar to) returns on U.S. stocks and real estate. A further difference in U.S.–Japan returns is that there is no sign of negative serial correlation (or mean reversion) for returns on Japanese real estate within a 7-year horizon. Returns on Japanese stocks also exhibit a weaker mean reversion process relative to returns on U.S. stocks and U.S. real estate.

This paper studies the return reversals of exchange-traded real estate securities using an arbitrage portfolio approach. Using the approach, we find that there exist significant return reversals in such securities. These return reversals could be exploited by arbitrage traders if trading costs can be ignored. However, the arbitrage profits disappear after deducting trading costs and taking into account the implicit cost of bid–ask spread. Thus, the real estate securities market is efficient at weekly intervals in the sense that one could not exploit the price reversals via some simple trading rules.

While a number of papers have investigated the time-series behavior of ex post bank stock returns and real estate returns, no study has comprehensively studied: (i) the relationship between ex ante risk premiums on both assets and (ii) the time-varying nature of such premiums in relationship to economic and real estate market conditions. In this study, we investigate how the changing nature of bank risk taking, especially in the real estate market, has affected the ex ante pricing of risk in the market for bank stocks. We find that the time variation in bank risk premiums are partly determined by interest rate and real estate market conditions. We also find that the real estate factor has been important for banks in the 1980s.

Casual observation suggests the prevalence of a "Santa Claus" approach to fund allocation, that is, giving more money to fund managers whose performance has been "nice" (good) in the recent past and less to those whose performance has been "naughty" (poor). We show that this backward-looking "Santa Claus" approach to asset allocation is not consistent with optimal portfolio management and that this may have contributed to the poor performance of financial institutions' real estate portfolios. We also discuss the role of loan-to-value ratio analysis and point out how this standard bank loan underwriting procedure may have affected commercial banks' "Santa Claus" strategy. We propose that this backward-looking strategy be replaced by either a simple buy-and-hold strategy or a contrarian investment strategy of increasing real estate exposure after a market downturn and reducing exposure after a market rally.

In this chapter we study the ex ante risk premiums on life insurance stocks and the time-varying nature of such premiums in relation to changes in economic environment, especially in the real estate market. We find that a premium for real estate risk is increasingly apparent in the market for life insurance stocks, presumably reflecting their growing exposures in this area. We also find some preliminary evidence that factor risks are underpriced for life insurance stocks. This underpricing is consistent with the presence of government safety net subsidies for the nation's public life insurance companies.

Previous studies have characterized emerging market equities as having higher returns, higher volatility, and higher predictability compared with developed markets returns. The recent Asian crisis has once again drawn attention to the return and risk feature of emerging market properties. Increasingly, conventional wisdom about emerging markets has been questioned because of the abysmal performance of these markets in times of adversity. Do real estate investment in emerging markets still offer attractive returns to U.S. investors? Do correlations across different markets increase in down markets so that the much desired diversifications may not be present when they are needed the most? Are real estate securities markets predictable in emerging markets? To answer these questions, we examine the behavior of the property indices' returns in 10 emerging markets.

This paper uses a multi-factor, latent-variable model to examine the time variation of expected returns on Asian property stocks. Using data from 1990 to 1997, we found strong evidence of time-varying risk premium, suggesting that property development based on constant discount rate may underestimate the cost of capital. A further study using a multi-country model suggests that conditional excess returns of many crisis-stricken economies appear to move quite closely with each other. This supports the hypothesis that the risk premiums in these Asian markets move closely over time. As a result, they provide a partial explanation of market contagion in the region

This chapter provides an empirical study of the relationship between institutional factors and real estate returns. Using data from both developed and emerging market countries, our empirical results show that institutional factors do influence real estate returns and that these factors may not be fully priced. We find that when controlling return volatility and level of economic growth, a higher property return is expected in countries where the economic growth, a higher property return is expected in countries where the economy is more efficient and has more economic freedom. Our results support the view that the combination of "lumpiness" of real estate investment and the volatile nature of international capital flows may expose property investors to extra investors to extra investment risk, which needs to be compensated. Our results also indicate that an improvement in a country's economic efficiency and economic freedom may reduce property variance risk.

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