City Research Online

Abstract

Since the early 2000s, globalisation in financial markets has been increasing, affecting the risk-return patterns experienced in different submarkets, such as the listed real estate sector. Macro-economic shocks, such as the global financial crisis (GFC) 2008, COVID pandemic 2020, inflationary pressure, interest rate rises or increases in the global political conflicts from 2022 onwards, have affected all investment sectors and industries. With the increase in global correlation and commonalities the assumption is that diversification benefits have partially diminished. This report aims to bring a deeper understanding into the systemic risks from and to the listed real estate (LRE)sector, and its role in portfolio selection and diversification against system-wide shocks. The findings are aimed to provide LRE investors and equity analysts with new tools and insights to manage their LRE exposure.
• Systemic importance of European LRE to other sectors: Findings confirm that when the European LRE sector is under stress, bank and non-bank financial sector equity indices show an increase in tail risk. Overall, firm size (measured by total assets) shows a positive correlation with systemic risk, meaning the larger the firm the more systemically important. While the findings of this study generally confirm the strong relationship between firm size and systemic risk, the data show that even small companies collectively can cause disruption to financial stability.
• LRE sensitivity to macro-economic shocks and financial market stress: Our findings suggest that large LRE companies are also more exposed to systemic events. The larger the real estate company, the more external relationships it typically has, hence it becomes more vulnerable to external shocks. Hence, these companies are more vulnerable to external shocks. However, the data show that the LRE sector recovery is quicker than the rest of the financial sector.
• Firm leverage and sensitivity to external shocks: Firm level leverage is an important factor, which can increase the vulnerability of a company to external shocks. A level of >50% leverage is typically considered high. However, firms can mitigate their systemic risk vulnerability by increasing their liquidity & income buffer. While net debt to EBITA gives the equity analyst important information about the financial risk of the company such as risk of bankruptcy, the level of LTV (overall leverage) says a lot the companies resilience to external market shocks. Investors and analysts should be aware of high leverage LRE companies, especially large stocks, and those located in markets where the performance of the sector is highly connected with the rest of the financial and macro-economic market of the country.
• Co-movements among LRE companies within the sector: Co-movements within the European LRE sector show that especially at times of low or negative returns, systemic risk and co-movement between companies is high. Therefore, a better understanding of dynamic movements in the real estate securities markets’ correlation structure and the forces behind market integration is important for investors to evaluate the potential risks and rewards of cross-country real estate diversification. Our findings indicate that the degree of co-movements between both country and sectoral LRE markets increases considerably during recession periods. The subject of interconnectedness is even more relevant now after the pandemic period and the Russia-Ukraine war led European economies into recession. According to our estimates, real estate market’ systemic risk and exposure indicators were more affected by the war-related uncertainty rather than the pandemic. More specifically, the degree of connectedness across the European LRE market is estimated to be rapidly increasing and has already overcome the 2008 peak value in most of the examined measures. Individual country markets which are less affected by the return and volatility movements of the overall European LRE market are Belgium and the UK. Here, equity analysts need to consider the regulatory and political interaction and integration of the LRE sector into its’ national market, when analysing an individual company.
• Long-term historic changes between systemic risk and LRE: LRE real estate in mixed asset portfolios can be defensive instrument to protect from systemic risks. Over the examined 20-year time period, times of increased co-movements coincide with periods of distress in the general stock market. However, LRE recovers more quickly than the rest of the financial market after these shocks. It can especially outperform other sectoral stock indices. The research finds that returns of LRE stocks hold up better during and especially after these crisis periods.
For this, LRE stocks have been empirically tested against 11 other industry sector indices. Based on the traditional mean-variance approach (MVT), real estate and healthcare companies account, on average, for 30% of the optimal allocation each followed by financial companies (20%), consumption products (7%), telecommunications (5%) and utilities (4%). Based on our portfolio selection exercise for different time periods, LRE companies perform well after recession periods, especially when the real estate cycle aligns with the economic cycle.
In addition to the mean-variance portfolio, in this study we employ an alternative specification based on minimizing portfolio’s systemic exposure. In other words, we construct a portfolio that minimizes the absolute value of the portfolio Value-at-Risk conditional on the market index being at distress, and not dispersion risk. Our findings suggest that LRE is featured in both selection specifications and provides diversification benefits against systemic exposure despite the recent distress in the real estate markets. LRE’s weight on the MVT optimal portfolio reached 41% after the sovereign debt crisis and 71% based on the Conditional VaR portfolio allocation. Especially after the period 2011 – 2019 the allocation of LRE in the optimal portfolio has been increasing while exposure to financial companies has been low only increasing again from 2015 onwards. As the inflationary pressures have weakened and interest rates have reached their peaks, we expect the degree of connectedness to decline as well, and the LRE sector to bounce back in 2024.
• Sector resilience to external shocks and systemic risk: Sector level differences are more relevant than country differentiation when determining the impact of external shocks to LRE companies. Equity analysts and investors should pay attention to a company’s underlying real estate market exposures. The most resilient sectors to external shocks are healthcare and residential LRE, while companies focusing on the classic property sectors office, retail and industrial show high comovements and spillover risks to external shocks. This is assumed to be caused by the high correlation with financial markets, employment, economic growth overall. This also leads to the conclusion that a diversified LRE company may be more exposed to external shocks than a more specialist one, which stands in contrast to the idea that a company should diversify its real estate portfolio. Over the last ten years residential real estate has become one of the most defensive real estate sectors for companies to invest in, when it comes to vulnerability to external shocks. Overall investors and equity analysts should consider alternative portfolio optimisation approaches which not only consider risk (volatility of returns) and portfolio return, but also integrate ideas of minimising systemic risk within their portfolios. These approaches can help minimise the vulnerability of the portfolio toward systemic shocks such as a recession, geo-political, macro-economic or financial market risks.

Overall investors and equity analysts should consider alternative portfolio optimisation approaches which not only consider risk (volatility of returns) and portfolio return, but also integrate ideas of minimising systemic risk within their portfolios. These approaches can help minimise the vulnerability of the portfolio toward systemic shocks such as a recession, geo-political, macro-economic or financial market risks.

Publication Type:	Monograph (Working Paper)
Additional Information:	EPRA encourages research teams to use elements of the research for academic publication in reviewed journals and for papers at conferences, possibly with extended analysis. While dissemination of the results in this manner is encouraged, the intellectual property rights over the findings and reports are vested in EPRA. However, EPRA grant the research team a perpetual licence free-of-charge for such academic purposes. The findings are made available for the exclusive use of EPRA for a period of six months after approval of the final report. Should the research team wish to use the research within this time period, permission from EPRA must be granted which will not unreasonably be withheld.
Publisher Keywords:	systemic risk, REITs, Connectedness
Subjects:	H Social Sciences > HD Industries. Land use. Labor
Departments:	Bayes Business School Bayes Business School > Finance
SWORD Depositor:	Symplectic Administrator

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