Impact of Liquidity Risk Perception on the Real Estate Risk Premium

When investing in commercial real estate, institutional investors consider liquidity risk the biggest risk factor. Consequently, liquidity risk affects the real estate risk premium required by investors. However, due to private real estate market characteristics such as informational inefficiency and segmentation, the liquidity risk perceived by individual investors is likely to differ from the actual market liquidity. The purpose of this study is to investigate the impact of perceived liquidity risk as reflected in institutional investor sentiment on the real estate risk premium over the period of Q1/1993 to Q3/2015 using time series analysis. Hereby our investigation accounts for the variable liquidity that differentiates the private real estate market from other asset markets such as the stock market. We expect the effect of perceived liquidity risk on the real estate risk premium to vary based on economic conditions. This expectation is in line with previous studies that find changes in investment behavior and risk preferences of institutional investors in the REIT and commercial real estate market during the 2007 to 2009 financial crisis (Das, Freybote and Marcato, 2015; Devos et al., 2013).Furthermore, our investigation accounts for the fact that the pricing of real estate risk by institutional investors is affected by the relative riskiness of commercial real estate compared to alternative investments such as REITs, stocks and bonds. Clayton, Ling and Naranjo (2009) find that the reduction in capitalization (cap) rates over the 2002 to 2007 period resulted from sentiment driven capital flows into commercial real estate. As a consequence, we also control for the impact of stock and bond market factors on the real estate risk premium. ReferencesClayton, J., Ling, D.C. and Naranjo, A. 2009. Commercial Real Estate Valuation: Fundamentals Versus Investor Sentiment. Journal of Real Estate Finance and Economics, 38:5-37.Das, P., Freybote, J. and Marcato, G. 2015. An Investigation into Sentiment-Induced Institutional Trading Behavior and Asset Pricing in the REIT Market. Journal of Real Estate Finance and Economics, 51(2), 160-189. Devos, E., Ong, S.-E., Spieler, A. C., & Tsang, D. (2013). REIT Institutional Ownership Dynamics and the Financial Crisis. Journal of Real Estate Finance and Economics, 47:266-288.