LFM-APV: A Monte-Carlo-Simulation-based risk model for real estate

The purpose of this paper is to enhance the granularity in the modelling of exogenous risk factors on financial performance of illiquid assets such as real property. In this context, financial literature has not connected those on alternative present value (APV) methods and on linear risk factor modelling (LFM) yet. The present piece fills this gap by setting up a formal method for applying this novel LFM-APV approach to modelling and pricing the risk for real estate investments. For this purpose, we design a theoretical framework consisting of a modern stochastic discounted cash flow model, which in turn is based on risk factors that are priced in using a linear factor model. Additionally, we illustrate the described pricing mechanism for standing investments based on real property data in an empirical study. Thus, we provide a clear algebraic solution to the problem of risk modelling for heterogeneous and illiquid investment positions such as direct real estate in a present value calculus. The practical implications to APV-LFM are the enhanced understanding of the functional relationship between underlying risk factors and the pricing of assets. The elaboration of the APV-LFM helps to have a better understanding of the functional relationship between underlying risk factors and the pricing of assets in practice.