Risk Factors in Private Commercial Real Estate

Purpose: This paper investigates real estate specific risk factors, such as location, liquidity, as well as market size, and evaluates the performance of commercial real estate. We use cash flow based information on individual property investments, instead of using aggregated index returns that are prone to the well-known appraisal bias or reflect a liquidity bias, such as transaction-based indices. Moreover, these issues are often coupled with a return-based methodology not catering to the distinguished characteristics of commercial real estate.Methodology: To circumvent these issues, this paper employs a cash flow based methodology labeled Generalized Public Market Equivalent (GPME) proposed by Korteweg and Nagel (2016). The GPME is a Generalized Methods of Moments (GMM) approach that accounts for cross-sectional dependence, different investment horizons, and skewed private commercial property payoffs. Our data obtained from National Council of Real Estate Investment Fiduciaries (NCREIF) contains 10,790 individual properties in the U.S. over the period January 1994 to December 2017. We test several asset pricing models ranging from Capital Asset Pricing Model (CAPM) to multi-factor models.Findings: The estimation results based on the NPI as benchmark portfolio suggest a discrepancy in performance between the larger and smaller Metropolitan Statistical Areas (MSAs), pointing to a real estate specific SMB factor. The model based on the CRSP stock market index is more robust to different sample periods and different assumptions on liquidation rates. We do not find systematic abnormal performance of private commercial properties compared to the stock market over the full sample period. In contrast, from sub-samples limited to a seven-year horizon, private commercial real estate does exhibit abnormal performance. Implications: From an investor perspective considering commercial properties as part of her portfolio, the results provide important information on the pricing of private commercial real estate. This is interesting for investors holding a diversified portfolio of traditional assets since adding private commercial real estate to the portfolio would not deteriorate the long-term performance but could provide steady cash flows from rental income and potential short-term excess returns.