RIESGO NO SISTÉMICO O DIVERSIFICABLE

The institutional sector of the property market is able to apply MPT to formulate an investment risk management strategy, because property indices provide relevant and accurate historical data on the performance of property types from which expected future returns may be calculated, as well as risk relating to deviations from the expected mean. The core of the purpose of an index is to provide a fair representation of market activity and price, where demand is met by supply. There is thus a duel function required from the market indicator: a measure of expected return from supplying the market and a measure of demand from the market. However, the relevance of application of the property index to the small investor for the formulation of an MPT-based risk management strategy is questioned, because of a number of contentious issues regarding the construction of indices. These issues relate to defining the population of the index, sample selection, sample size and a lack of price information.

It was discovered that the heterogeneous nature of property largely determines value and hence capital growth. Capital growth is a major contributor of asset-specific risk. As a rule therefore, a large portion of the risk contained in property indices is attributable to asset-specific risk and therefore renders indices less relevant to small property investments. The lack of a central trading facility for property leads to an inconsistency in the determination of price and value. The index figures on total return, which broadly speaking consists out of capital growth and income growth, may be unrelated to one

another and not be a true reflective of the market, since asset-specific risk will be present in a constructed market portfolio. It is argued that figures relating to income and rent are more reflective of the general property market demand.

It was determined the difference between indices depends on sample size. The total risk of a direct property investment comprises market- or external risk as well as asset- specific (internal) risk. If a market portfolio (index portfolio) is constructed, asset specific risk will thus also be present, but will reduce as sample size increases. If an index therefore includes all property (and property types), all asset specific risk will be eliminated, leaving thus only market risk to remain. Therefore, the larger the portfolio, the less asset-specific risk will be contained in the market portfolio. Similarly, the larger the index from which a market portfolio is constructed, the more true the reflection of risk contained in the market would be. Accuracy of an index with respect to a fair reflection of market risk is therefore highly dependant on scale and size. Thus the larger the investment, the more relevant the index would be in its application of reflecting market behaviour. From this point of view, the necessary calculations and procedures to apply MPT are therefore relevant to large investments or portfolios, but less so for smaller portfolios and small single property investments.

However, if the use of specific index figures is avoided and only general indicators are used, the index is of value at the macro-scale of the property market and may thus be of use when general market behaviour is to be determined. This affords the opportunity of comparison with other macro-economic indicators, which may facilitate the determination of property market activity relative to macro-economic behaviour.

The application of an index as a market indicator of expected return to the small individual property is therefore not acceptable due to the presence of asset-specific risk contained in the index. However, it was discovered that if the income approach to valuation is followed, the dependency on index-derived values for capital growth is eliminated. The effect of asset-specific risk originating from the index will therefore be reduced, since potential variance on income will be more reflective of the market. The

capital growth derived from income will thus also be more closely related to the market. The overall market risk (relating to both income and capital growth) will therefore have less asset-specific risk. Thus, if a market portfolio is constructed specific for the individual investment, which is based on income, and capital value is derived from rent using the income approach, the expected return from the market will be a hypothetical expected return curve specific for the individual investment, which takes into account the individual characteristics of the property, yet still be reflective of general market behaviour. The risk calculated from potential variance of expected income, will thus be market reflective and will exclude asset-specific risk. The income approach to valuation in the determination of capital value also finds suitable application in the DCF, as was suggested in Chapter 3.

The necessary calculations to determine market risk for the investment therefore relates to overall performance and are represented by a premium to be added to the discount rate. From the above argument it can therefore be deduced that income from an index may be justifiably used as a single indicator of property market behaviour, since it is also indicative of capital growth and value. The calculated market risk (variance) from rental will thus also include risk pertaining to capital growth and value. It is therefore proposed that the use of income, as a market indicator from this point of view, may be regarded as an acceptable indicator of the supply side of the market equation and thus perform this function to a similar effect as overall return.

Indices essentially are to function as a necessary link between the investment and the market by providing a historical account of market performance. The information is basically indicative of equilibrium price where supply had been met by demand. The supply side of the intended function of an index for application to the small investor has been clarified. But in order for the alternative indicator (rent/income) to perform the same function as an index, it must also be reflective of market demand. The demand for property may thus be regarded as an initial step towards an alternative property market indicator.

However, the quantification of property demand as a market indicator presents problems, which are related to the structure of the property market. In terms of the Four Quadrant model of the property market, only the rental market responds to stimulus from out side the market in the macro-economy. Rental therefore may be considered from a theoretical point of view as a single indicator of property demand and is justified if the income approach to valuation is applied to determine capital value and growth, as had been indicated previously. This is also consistent with the use of rental as an indicator of supply-side market behaviour. The demand for space is driven by the general demand for business in the macro-economy. The demand for property therefore is thus not direct, but a derived demand from the demand for business. The demand for business may therefore be considered as an evolution of the initially identified link of property demand as an alternative link between the property market and the individual investment.

The question arose on how business demand is quantified? Using macro-economic theory the demand for business was quantified as follows:

The demand for property is a derived demand from the demand for goods and services in business – represented by Aggregate Demand. The measure of Aggregate Demand is GDP, since it is a measure of Aggregate Supply meeting Total Demand in the macro- economy. GDP may therefore be regarded as a theoretical indicator of the demand for business. However, Monetarist macro-economic theory teaches that inflation is a by- product of economic activity and escalates during periods of sustained levels of high Aggregate Demand. Monetarist economic theory aims to control the levels of inflation, by regulating levels of Aggregate Demand in the economy, through changes in the domestic money supply, which is achieved by government through the fluctuation of the primary lending rate (Repo Rate) of the South African Reserve Bank (Monetary Policy). Variance in the demand for business and hence the demand for property constitutes risk. Market risk for property is therefore linked to both inflation and interest rate, since income levels of business are inflation- and interest rate prone. There is thus merit in the hypothesis that interest rate, inflation and GDP could equally be used as potential indicators of the demand for business and hence also of the property market.

6.4 DETERMINING THE RELATIONSHIPS BETWEEN THE MAIN