Residential property market performance and extreme risk measures

Abstract

Abstract Residential property is a popular investment option and has historically attracted small Australian individual investors with debt financing lowering the initial equity component, favourable tax structure and past evidence of good returns. A major concern with this approach is uncertainty, where stable assumptions cease to hold and there is concentrated negative price movement. This extreme downside volatility may not be fully reflected in traditional risk calculations. This research studies 40 years of quarterly Melbourne established residential property market performance data for normal distribution features and signs of extreme downside risk. The results show that the normal bell curve distribution underestimated actual extreme values both by frequency and extent for ungeared residential property data. This is magnified as the gearing is increased to an extent where the outermost data point on 80% debt leverage shows an unrealistic probability of a 1 in 192 year event. Alternatively adopting the Cubic Power Law of returns, the probabilities of the most extreme event occurring drops to a realistic 1 in 38 year event. In highlighting the challenges to measuring the impact of leverage on residential property market performance, the analysis of extreme downside risk should be separated from traditional standard deviation risk calculations.