The Real Estate Risk Premium Puzzle: A Solution1

For decades, performance comparisons between real estate and financial assets have repeatedly indicated that private real estate investment exhibits significantly higher risk-adjusted returns than publicly traded financial assets such as common stocks. That is, there is an apparent “real estate risk premium puzzle. ” In this paper, we find that the seemingly superior risk-adjusted returns of real estate may be caused by inappropriate adoption of the conventional risk measure to real estate, a measure that completely ignores the non-i.i.d. nature of the asset’s return distribution, as well as its illiquidity risk. We develop a modified performance measure—a Sharpe ratio for real estate—to capture the time-dependent nature of real estate risk by incorporating illiquidity risk in a closed-form formula. Our finding shows that, once the real estate risk is properly measured, the long-standing “real estate risk premium puzzle ” no longer exists. Our approach also shows that real estate price risk over time can be accurately obtained through empirical estimation without relying on a simplification assumption of a particular distribution like the i.i.d. assumption