MODULE 1 UNIT 3

Quantifying risk

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Table of contents
1. Introduction 3
2. Quantifying and measuring risk 3
3. The relationship between risk and expected return 6
4. Comparing risk and return 7
5. Conclusion 10
6. Bibliography 11

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Learning outcome:

LO4: Calculate the standard deviation (a measure of risk) of different real estate
investment projects.

1. Introduction
Commercial real estate investors invest their funds to make money. However, any
investment, regardless of the underlying asset type, is risky, as investors might not get the
returns they expected. In this set of notes, you will learn how to measure and quantify the
risk that a real estate investment is exposed to, enabling you to make more informed real
estate investment decisions.

2. Quantifying and measuring risk

Think of an investment you are considering. How well the investment performs depends
on unknown, and sometimes unknowable, events in the future. Once the future has
happened, there is only one reality. However, before then, from the point of view of the
present, you can think of there being a probability distribution that will govern the future
outcome. From that point of view, there are many possible outcomes, and you can think of
there being a probability associated with each outcome occurring. For example, one
outcome might be that you achieve a return greater than 20%. Another outcome might be
that your return is less than 0%.

Looking at Figure 1, the possible outcomes are measured by the returns shown on the
horizontal axis. The probability of achieving any given return is indicated by the height of
the curve above the horizontal axis. In this example, all three investments (A, B, and C)
have the same expected return of 10%. However, they all have different risks associated
with this return. (This figure is just used as an example; in real life, you would not expect
assets with different risk profiles to sell at prices that would give them the same expected
return.)

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Figure 1: Measuring risk using standard deviation. (Adapted from: Geltner et al. 2014, 187)

The range of this probability distribution can be used to quantify the amount of investment
risk that an investor is exposed to. For example, looking at Figure 1, you can see that Asset
A is risk free as there is a 100% chance that the asset will yield a return of 10%. Asset B
is riskier as the return could range from about 5% to 15%. Asset C is the riskiest as there
is a chance that the yield could be as low as −7%.

You will never know for sure exactly what this ex ante probability distribution is. However,
you can use empirical historical data about real estate prices and investment performance
to gain some confidence about the relevant probability distributions.

The expected return on an investment is defined as the mean of the ex ante probability
distribution, while the risk associated with the investment is measured by the standard
deviation in that distribution. If you have empirical data (historical time-series of holding
period returns, as defined earlier), then the time-weighted average may provide an
indication of the expected return if the historical sample is unbiased and representative.
The standard deviation in the returns across the historical series provides an indication of
the risk as measured by the volatility.

Example 1 illustrates how to quantify return risk in practice.

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Example 1:

Imagine that there are two possible future scenarios: a gain or a loss. There is a 50%
probability of a 20% gain and a 50% probability of a 10% percent loss. The expected return
is calculated by multiplying the possible outcomes by their associated probabilities.

(0.5)(20) + (0.5)(−10)

= 10% − 5%

= 5%

The result is an expected return of 5%. In other words, 5% is the mean of the return
probability distribution. (Even though the actual return will not be 5% in this case, it will
either be 20% or −10%.)

To calculate the standard deviation, subtract the mean (i.e., the expected return) from each
possible result. Then, calculate the square of each of those differences and multiply each
of those squared deviations by the probability associated with that outcome. Finally, add
these products together and calculate the square root of the sum.

= SQRT[(0.5)(20 − 5)2 + (0.5)(−10 − 5)2]

= SQRT[(0.5)(225) + (0.5)(225)]

= SQRT(112.5 + 112.5)

= SQRT(225)

= 15%

In this example, the standard deviation, or the measure of risk, is 15%. Notice that + or −
15% does in fact describe how the two outcomes, +20% and −10%, deviate from the
expected return of +5%. 20% is 15% above 5%, and −10% is 15% below 5%.

In practice, the standard deviation of investment returns is often estimated using price
indexes if such empirical data is available. The risk may be quantified based on the
volatility, which is the standard deviation of the returns across time.

In principle, the returns that matter most for investors are the total returns, i.e., capital
return plus income return (r = y + g). Figure 2 shows an example of commercial property
total return indexes tracking several submarkets in two US metro areas (New York and
Chicago).

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Figure 2: Cumulative total returns (income and capital gain) of commercial properties in two US
cities. (Adapted from: MIT Center for Real Estate Price Dynamics Platform, 2018).

Notice that the submarkets with faster growth (i.e., higher investment returns on
average) also seem to exhibit more volatility or investment risk (bigger swings or
more ups and downs over time). This is typical of the relationship between risk and
return observed in asset markets over time: greater returns are associated with greater
risk.

3. The relationship between risk and expected

return
As is hinted at in Figure 2, the amount of risk an investor is willing to accept has an
impact on the expected return (and vice versa). In Video 1, Professor Geltner
illustrates this concept, and the relationship between risk and expected return, visually.

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Video 1: How the amount of risk an investor takes on influences the expected return.

4. Comparing risk and return

Examples 2 to 4 are numerical examples that compare two real estate investments,
Property A and Property B, to illustrate the relationship between risk and return in a more
concrete way.

Example 2:

Suppose that you buy two properties at a price of $100,000 each at the beginning of the
year. Property A is an apartment and Property B is a small hotel.

There is a 50% probability that Property A will be worth $110,000 at the end of the year
and a 50% probability that it will be worth $90,000. In other words, there is a 50% probability

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that Property A will be worth 10% more at the end of the year and a 50% probability that it
will be worth 10% less.

The expected return (apart from income) is calculated as follows:

(0.5)(10) + (0.5)(−10)

= 0%

The standard deviation of Property A is calculated as follows:

= SQRT [(0.5)(10 − 0)2 + (0.5)(−10 − 0)2]

= SQRT[(0.5)(100) + (0.5)(100)]

= SQRT(50 + 50)

= SQRT(100)

= 10%

Property B has a 50% chance of being worth $120,000 and a 50% probability of being
worth $80,000.

The expected return is calculated as follows:

(0.5)(20) + (0.5)(−20)

= 0%

The standard deviation of Property B is calculated as follows:

= SQRT[(0.5)(20 − 0)2 + (0.5)(−20 − 0)2]

= SQRT[(0.5)(400) + (0.5)(400)]

= SQRT(200 + 200)

= SQRT(400)

= 20%

Based on their respective standard deviations, Property B is riskier than Property A, as it

has a higher standard deviation.

Example 3:

Using the same example as before, suppose that the risk-free interest rate is 7%. Also
assume that the apartment generates a net rent amount of $11,000 for the year, and the
hotel generates a net income of $15,000.

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Using the r = y + g formula, the expected ex ante total return on the apartment is as follows:

r=y+g

= ($11,000 / $100,000) + [($100,000 − $100,000) / $100,000]

= 11% + 0%

= 11%

The expected ex ante total return on the hotel is as follows:

r=y+g

= ($15,000 / $100,000) + ($100,000 − $100,000) / $100,000

= 15% + 0%

= 15%

The ex ante risk premium for the apartment is the following:

RP = r − rf

= 11% − 7%

= 4%

The ex ante risk premium for the hotel is the following:

RP = r – rf

= 15% − 7%

= 8%

The investor is therefore paying twice the risk premium to get an additional $4,000 in
expected returns. Notice that the ratio of the risk premiums (8 / 4 = 2) is the same as the
ratio of the risk in terms of the standard deviations of the returns (20 / 10 = 2).

Example 4:

Now, suppose that there was a favorable outcome for Property A, with the value of the
apartment increasing from $100,000 to $110,000. Property B, however, experienced an
unfavorable outcome, with the value of the hotel decreasing from $100,000 to $80,000.

The ex post total return on the apartment is as follows:

r=y+g

= ($11,000 / $100,000) + ($110,000 − $100,000) / $100,000

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= 11% + 10%

= 21%

The ex post total return on the hotel is as follows:

r=y+g

= ($15,000 / $100,000) + ($80,000 − $100,000) / $100,000

= 15% + (−20%)

= −5%

The ex post risk premium (or excess return) for the apartment is the following:

RP = r – rf

= 21% − 7%

= 14%

The ex post risk premium for the hotel is the following:

RP = r – rf

= −5% − 7%

= −12%

Of course, no one knows which outcome will occur in the future. But the greater ex ante
risk in the hotel no doubt led to its price being low enough to provide the higher ex ante
risk premium of 8% compared to 4%. In Example 4, the “dice rolled unfavorably” for the
hotel and favorably for the apartment. But it could have been the opposite, or favorable for
both or unfavorable for both, and with equal probability ex ante. This is the nature of
investment risk. If markets are efficient, the prices, and hence the expected returns, will
reflect the information that investors have (or believe they have) about the relative risk in
the various investments. If you want to have a higher expected return, you generally will
have to take on more risk, as shown in this simple example of the apartment and the hotel.

5. Conclusion
In this set of notes, you explored the relationship between risk and return. In general, the
higher the risk an investor is exposed to, the higher the return is expected to be, but the
greater the potential losses or probability of loss. You also saw that, in theory, it is possible
to quantify and measure the amount of risk an investment is exposed to, making use of
empirical data to estimate the probability of certain outcomes. Although it is not an exact
science, the numbers calculated in this manner should provide real estate investors with
more confidence about the investments they plan on making. Empirical information about

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property markets makes investment more transparent, replacing uncertainty with risk. This
makes the markets more efficient and effective at appropriately pricing assets and
allocating investment capital.

6. Bibliography
Geltner, David M., Norman G. Miller, Jim Clayton, and Piet Eichholtz. 2014. Commercial
Real Estate: Analysis and Investments. 3rd ed. Mason, OH: OnCourse Learning.

MIT Center for Real Estate Price Dynamics Platform. 2018. Total Return Report: 2018Q1.

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