Convergence in the UK direct real estate market

Published date03 July 2017
DOIhttps://doi.org/10.1108/JPIF-06-2016-0043
Pages382-396
Date03 July 2017
AuthorStephen Lee
Subject MatterProperty management & built environment,Real estate & property,Property valuation & finance
Convergence in the UK direct real
estate market
Stephen Lee
Cass Business School, City University of London, London, UK
Abstract
Purpose The purpose of this paper is to empirically examine the issue of convergence in the monthly
returns, rental growth and yields for ten market segments in the UK direct real estate market, using monthly
data over the period from January 1987 to December 2014.
Design/methodology/approach The methodology used to determine convergence is principal
component analysis as it provides an assessment of the extent to which the variance of the market segments
can be represented by a single common factor, explaining their long-run behaviour, and the degree of
independence between the market segments.
Findings The results suggest that there is strong evidence of convergence over the entire sample period in
relation to monthly returns and yields but less evidence of convergence in rental growth, which confirms the
findings in previous studies in international markets.
Practical implications The evidence also suggests that convergence has increased over the sample
period and that convergence is period specific and was particularly strong during and after the period of the
Global Financial Crisis, which implies that the UK direct real estate market is largely integrated and as a
consequence the extent of diversification potential in the market is still severely limited.
Social implications The convergence in returns has crucial implications for investors as it leaves
investors exposed to the same structural shocks and so magnifies the importance of volatility spillover
effects, limits their ability to create well-diversified portfolios and make it more difficult for fund managers to
outperform the market.
Originality/value This is the first paper to examine the convergence in the UK direct real estate market.
Keywords Convergence, Yields, Principal component analysis, Returns, Rents, UK direct real estate
Paper type Research paper
Introduction
It can be shown that all financial assets are driven by a small number of risk factors, where a
factor is any characteristic that is important in explaining the risk and return of a group of
assets. The factor structure of asset returns has crucial implications for the success of
portfolio performance. For instance, if assets display the same factor structure an investors
ability to create a well-diversified portfolio is severely limited. But, if assets display differing
factor structures it is easier to develop a well-diversified portfolio. Indeed, Meucci (2009)
contends that portfolio managers comprehend a portfolio to be well diversified if it is not
heavily exposed to individual shocks, or factors.
The oldest and most well-known factor model is the capital asset pricing model (CAPM)
of Sharpe (1964), Lintner (1965) and Mossin (1966), which suggests that there is only one risk
factor that arises from exposure to the market and is captured by β, the sensitivity of an
assets return to the market. Ross (1976) proposed a different theory of what drives asset
returns, the arbitrage pricing theory (APT). This approach suggests that the expected
return of assets can be modelled as a function of various macroeconomic factors or
theoretical market indexes. Importantly, unlike the CAPM, APT does not explicitly identify
the number of priced factors. But the number of priced factors explaining the long-run
cross-sectional performance of asset returns can be extracted through principal component
analysis (Roll and Ross, 1980).
Becker and Hall (2009a, b) argue the extent of convergence in asset returns, explaining
their long-run behaviour, can be assessed by the similarity in the factor loadings and the
percentage R
2
of the first principle component. For instance, if the first principle component
explains only a small amount of the return variance and the factor loadings are largely
Journal of Property Investment &
Finance
Vol. 35 No. 4, 2017
pp. 382-396
© Emerald PublishingLimited
1463-578X
DOI 10.1108/JPIF-06-2016-0043
Received 22 June 2016
Revised 30 August 2016
Accepted 21 December 2016
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1463-578X.htm
382
JPIF
35,4

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