In commercial real estate, volatility refers to the stability of a CRE investment based on market demand.
There are two main types of volatility: historical and implied. Historical volatility is most relevant in CRE. While implied volatility is essential for determining option value in stock futures trading, it’s not typically utilized in most commercial real estate valuations since CRE assets are tangible.
REITs (Real Estate Investment Trusts) are publicly traded real estate funds that offer options, which means implied volatility could be calculated. However, REIT portfolios consist of many CRE assets, which hedges risk for investors.
When calculating volatility on single CRE properties, historical data is the best method.
Historical Volatility in Real Estate
Volatility is measured by historical fluctuations of the asset’s price over time.
A commercial property that has experienced erratic price swings over a short period is considered highly volatile to investors. Conversely, one that has remained stable and has provided consistent returns over time is not considered volatile, but rather a more stable investment.
Understanding a CRE property’s volatility history is crucial for investors to decide if an asset is worthy of a long-term investment.
How to Calculate Volatility in Real Estate
In commercial real estate, you can calculate an asset’s volatility by determining a standard deviation of returns over a period of time.
Calculating the annual standard deviation is common for most investments. However, since CRE assets are more commonly utilized for long-term investing, wealth managers calculate the volatility of an asset over periods between one and twenty-five years.
Sample Volatility Calculation for Commercial Real Estate
Imagine you want to determine the volatility of an asset over five years. Below is an example of how to calculate volatility for a CRE property.
Find the average market valuation (in millions):
7 + 9.5 + 10 + 12 + 14 / 5 = 10.5
In the first step, you add up each year’s market valuation and divide it by the number of years (5).
Calculate the difference between each year’s valuation and the average valuation
Year 1: 7 – 10.5 = -3.5
Year 2: 9.5 – 10.5 = -1
Year 3: 10 – 10.5 = -.5
Year 4: 12 – 10.5 = 1.5
Year 5: 14 – 10.5 = 3.5
Square the difference from the previous step:
Year 1: (-3.5) squared = 12.25
Year 2: (-1) squared = 1
Year 3: (-.5) squared = .25
Year 4: (1.5) squared= 2.25
Year 5: (3.5) squared= 12.25
Sum the squared differences
12.25 + 1 + .25 + 2.25 + 12.25 = 28
Find the variance
Variance = 28 / 5 = 5.6
Find the standard deviation
Standard deviation = 2.37 (square root of 5.6)
This means that this example CRE property’s price can potentially deviate $2.37M over five years, assuming that no other capital is invested into the property.
Although volatility exists in any investment, most investors turn to CRE investments because of their stability. In many cases, CRE investments have a set ROI goal to be achieved by a particular date. CRE asset managers employ many different investment strategies that can involve various steps such as building, renovating, re-zoning, refinancing, and more to meet their client’s investment goals.