Beta (levered beta) measures the systematic risk (also known as volatility or market risk) of a portfolio or asset when compared to the whole market. It’s primary use is in the capital asset pricing model (CAPM), which calculates the systematic risk of an asset or portfolio.
On its own, beta will only give an investor an approximation of the risk of an individual stock. It must be applied to a calculation or model (e.g. CAPM) to give accurate results.
The beta coefficient will represent the angle of the line through a number of data points. For example, below is the beta of The Black Stone Group (source):
Here you could observe the relationship between the company and the general market.
To calculate the beta of an individual stock, you must divide the product of the covariance (the stock’s returns and the market’s returns) by the variance of the market’s returns over a defined period of time.
The formula for beta is as follows:
Beta Coefficient (𝛽) = Covariance (return of individual stock, return of the overall market) / Variance (return of the overall market)
If the value of beta < 1, the stock most likely is less volatile than the market. Adding a stock with a beta value less than one to a portfolio, will reduce the portfolio’s risk.
If the value of beta > 1, the stock is theoretically more volatile than the market. Adding a stock with a beta value greater than one to a portfolio, will add any risk. However, it could increase the return.
If the value of beta = 1, the stock’s valuation is strongly correlated with the market. Adding a stock with a beta value of one to a portfolio, will not add any risk.
However, if the beta value is negative this means that the stock moves inversely to the market.
It is important to remember that beta may not always predict a stock’s future accurately. This is due to beta assuming that a stock’s returns are normally distributed — this is often not the case.
Due to its limitations, it is useful when determining a stock’s short-term risk as well as in CAPM. When used to predict long-term risk, beta becomes ineffective.
How Does this Apply to Commercial Real Estate?
Every asset in the commercial real estate industry has different expected betas. The hotel sector, for example, has the highest beta and is considered the riskiest property type. This is because hotels rely on room rentals and can suffer during economic downturns, including COVID-19.
The office space sector is generally sensitive to economic conditions due to employers firing and hiring workers in accordance with the market.
Retail has the lowest beta among all five property sectors due to longer leases and continued consumer spending.