Idiosyncratic risk in direct property - a review of the literature

The literature concerning idiosyncratic risk in securitised property is relatively extensive compared to that for direct property. While the risk classifications of systematic, unsystematic and specific/idiosyncratic have been proven to exist within direct property portfolios through quantitative analysis, little research has been undertaken to better understand the nature and contribution of specific/idiosyncratic risk. Reflecting portfolio theory, in a direct property portfolio the contribution of specific/idiosyncratic risk can be effectively neutralised through holding a diversified portfolio with a sufficient number of assets. Quantitative research has focused on the appropriate number of assets to be held in the portfolio to neutralise the contribution of specific/idiosyncratic risk but little research has been undertaken to examine the nature of specific/idiosyncratic risk in direct property. The literature tends to gravitate towards specific/idiosyncratic risk as a function of location, building and tenant which, by definition, vary between buildings as two locations can never be identical. However, in a sub-sector such as CBD office, considerable commonality may exist between location, building and tenant to the point of being partially unsystematic risks rather than specific/idiosyncratic risks. For example, all office buildings in the CBD sub-sector have significant locational or spatial similarity, albeit with some minor differences as distance from the core increases. Further, many office buildings in the CBD sub-sector will have significant building similarities, often being on average newer and built to a higher specification than in other areas. Tenant may also have some commonality across office buildings in the CBD sub-sector with generally stronger tenant covenants and generally longer leases than may be found in other areas. Accordingly, in the context of office buildings in the CBD sub-sector, aspects of that previously considered to be specific/idiosyncratic risk may be unsystematic risk. The paper seeks to review and analyse the literature to explore where traditional concepts of specific/idiosyncratic risk as a function of location, building and tenant may be challenged and to posit the hypothesis that specific risk may be different to idiosyncratic risk in the context of office buildings in the CBD sub-sector.