Downside risk is a measure of property investment risk that focuses on the potential of under-performance of an investment below a target or required rate of return.
The most commonly metric used for measuring the risk of investments in a particular property type is the standard deviation of returns. This metric measures the volatility of returns around the mean. Higher standard deviation would mean higher volatility of returns and higher risk.
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It should be noted though that the standard deviation takes into account deviations both above and below the mean of the distribution. This would not be an issue, if the following three conditions held: 1) investors set their target return always equal to the mean of historical returns, 2) the deviations are symmetrically distributed above and below the mean (normally distributed in statistics terminology) and 3) investors consider deviations above a target return equally risky as deviations below the mean.
First of all, in most cases real estate investors do not set their target return equal to the mean of historical returns. Second, empirical research has shown that real estate investment returns are not normally distributed.
Finally, most investors would not consider deviations above their required return as risk but as a bonus. The risk of under-performance is reflected in potential deviations of expected returns below the required return not above it. Here is where the concept of downside risk becomes relevant.
Example of Calculation of Downside Risk
The downside risk can be calculated as the downside deviation of a historical return series. We show in Table 1 below some hypothetical historical office and industrial property returns over the last 24 years. We assume a target return of 8% for both types of investment and we calculate the downside risk as the deviation of returns below this target rate. This is calculated by deducting from the return of each year the target rate of return only in the years that this return is lower than 8%. For the years that the return is equal or above 8% this difference is set equal to zero.
Subsequently, we square this difference and sum it up for all years for each property type. This shown in the table in the row “Sum” for the last two columns in which we have the squared deviations below the target return for each property type.
To calculate the downside deviation, which is shown in the last line of the table, we simply take the square root of this sum divided by 23. We divide by 23 (24-1) and not 24, which is the total number of years for which we have historical returns, because this is a sample of the historical performance of the two property types.
This example illustrates how the downside risk measure (the downside deviation) can lead to different conclusions in terms of which property type has the greatest investment risk. According to the simple standard deviation measure, offices appear to be slightly more risky than industrial (8.7% vs 8.5%, respectively, but according to the downside risk measure industrial property investments are clearly and considerably more risky (7.4% vs 6.4%), respectively.
Table 1 Example of Calculation of Downside Deviation
| Office Return | Industrial Return | Roff – Rtarget | Rind – Rtarget | (Roff – Rtarget)2 | (Rind – Rtarget)2 | |
| 1 | 12.4% | 8.7% | 0 | 0 | 0 | 0 |
| 2 | 9.1% | 9.9% | 0 | 0 | 0 | 0 |
| 3 | 5.7% | 9.9% | -2.3% | 0 | 0.1% | 0 |
| 4 | 4.0% | 8.7% | -4.0% | 0 | 0.2% | 0 |
| 5 | 6.0% | 2.0% | -2.0% | -6.0% | 0.0% | 0.4% |
| 6 | 4.1% | -3.9% | -3.9% | -11.9% | 0.1% | 1.4% |
| 7 | -1.1% | -4.5% | -9.1% | -12.5% | 0.8% | 1.6% |
| 8 | -11.4% | -0.8% | -19.4% | -8.8% | 3.8% | 0.8% |
| 9 | -8.0% | 7.6% | -16.0% | -0.4% | 2.6% | 0.0% |
| 10 | -3.9% | 12.3% | -11.9% | 0 | 1.4% | 0 |
| 11 | 3.9% | 13.6% | -4.1% | 0 | 0.2% | 0 |
| 12 | 7.2% | 15.9% | -0.8% | 0 | 0.0% | 0 |
| 13 | 13.6% | 15.9% | 0 | 0 | 0 | 0 |
| 14 | 17.9% | 11.6% | 0 | 0 | 0 | 0 |
| 15 | 19.6% | 14.0% | 0 | 0 | 0 | 0 |
| 16 | 12.2% | 9.3% | 0 | 0 | 0 | 0 |
| 17 | 14.1% | 6.7% | 0 | -1.3% | 0 | 0.0% |
| 18 | 6.2% | 8.2% | -1.8% | 0 | 0.0% | 0 |
| 19 | 2.8% | 14.9% | -5.2% | 0 | 0.3% | 0 |
| 20 | 5.7% | -5.8% | -2.3% | -13.8% | 0.1% | 1.9% |
| 21 | 12.0% | -17.9% | 0 | -25.9% | 0 | 6.7% |
| 22 | 19.5% | 9.4% | 0 | 0 | 0 | 0 |
| 23 | 19.1% | 14.6% | 0 | 0 | 0 | 0 |
| 24 | 20.5% | 16.0% | 0 | 0 | 0 | 0 |
| Standard Deviation | 8.7% | 8.5% | ||||
| Sum | 9.5% | 12.7% | ||||
| Downside Deviation | 6.4% | 7.4% |
Related
As an expert in real estate investment and risk management, I bring a wealth of knowledge and experience to the table. I have a deep understanding of the various metrics and concepts used in property investment analysis, including downside risk, standard deviation, and their implications for assessing investment risk.
Let's delve into the key concepts mentioned in the article:
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Downside Risk:
- Definition: Downside risk is a measure of property investment risk that focuses on the potential under-performance of an investment below a target or required rate of return.
- Importance: It provides a more nuanced perspective on risk by specifically addressing the possibility of returns falling below the desired threshold.
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Standard Deviation:
- Definition: Standard deviation is a metric used for measuring the risk of investments in a particular property type. It quantifies the volatility of returns around the mean.
- Importance: Higher standard deviation indicates higher volatility of returns and, consequently, higher investment risk.
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Assumptions and Challenges with Standard Deviation:
- Assumption 1: Investors setting target returns equal to the mean of historical returns is uncommon in real estate investment.
- Assumption 2: Real estate investment returns are not normally distributed (deviations from the mean are not symmetrical).
- Assumption 3: Investors generally consider deviations below the required return as risk, not deviations above it.
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Calculation of Downside Risk:
- The article provides an example of calculating downside risk using the downside deviation of a historical return series.
- The calculation involves setting deviations above the target return to zero and squaring and summing the deviations below the target return.
- The result is the downside deviation, which offers a different perspective on investment risk compared to standard deviation.
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Example Illustration:
- The article presents a table illustrating hypothetical historical office and industrial property returns over 24 years.
- A target return of 8% is assumed for both property types.
- The downside risk measure (downside deviation) leads to different conclusions compared to the standard deviation measure, highlighting the importance of considering downside risk.
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Conclusion:
- The example concludes that, based on the downside risk measure, industrial property investments are considerably more risky (7.4% downside deviation) compared to offices (6.4% downside deviation).
In summary, understanding and incorporating downside risk alongside standard deviation is crucial for a comprehensive assessment of real estate investment risk. This nuanced approach better aligns with the complexities of the market and investor preferences.
