Risky Misperceptions: Defining Systematic Market Risk

MANY CITIES PERCEIVED TO BE LOW RISK ARE ACTUALLY QUITE RISKY

(Via Green Street Advisors) Valuations frequently part ways across public and private real estate markets, with a big reason being that some investment criteria that are important to participants in one market are often of little or no use to those in the other. Two concepts that fit into that box involve the manner in which institutional property investors (e.g., pension funds, SWFs, etc.) value liquidity and risk.

Liquidity is widely viewed as a desirable trait by private-market investors. As a result, large coastal markets that have high aggregate transaction volumes and/or turnover typically have lower cap rates due, in part, to the premium investors are willing to pay for it. The rationale for this premium, however, defies logic, as these same investors have lengthy investment horizons and urgency in the transaction market is neither possible nor necessary.

Many institutional investors also embrace the largest markets due to their perceived low risk. However, a systematic review of market risk shows that several of the large gateway markets are among the riskiest markets in the country. Curiously, markets with the highest risk tend to have the lowest cap rates. 

Public investors reject both views, as REITs with outsized exposure to markets that are liquid and/or risky tend to trade at larger discounts to NAV. In the face of dubious logic on the part of institutional property investors, that seems appropriate.

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