Residential real estate, risk, return and diversification: some empirical evidence

This paper outlines and applies a methodology for estimating and examining the variation in risk and return for individual homes. This is important because most households own individual properties and the risk and return profile of each of these may differ. We use large data sets of home prices and rents for Sydney, Australia, from 2002-16, and estimate flexible smoothing spline hedonic models. These models are used to construct total returns—the sum of capital gains and the rental yield net of costs—for the homes in our data. We find that Sydney homes had, on average, both higher returns than shares and much lower risk. This gave them a far superior Sharpe ratio. Moreover, while we find that shares benefit to a greater extent from diversification than homes, the Sharpe ratio of a large portfolio of shares was still well below that of the average single home. Interestingly, we find that much of the variation in risk and return across properties can be explained by observable home characteristics. In particular houses had stronger returns than did apartments.