In spite of the uncertainties risk appetite remains strong, with investor focus set to shift to near-prime and possibly secondary assets, writes Sotiris Tsolacos

Abrupt changes in risk premia and sharp asset price movements have been associated with shifts in risk appetite. Gauging the degree of investors' risk appetite and assessing how it changes through time helps in understanding the possibilities of risk repricing and forthcoming financial instability. Therefore, there has been significant work to measure risk appetite, especially after the Mexican peso crisis in 1995, to extract signals of forthcoming periods of financial turbulence. Given the emphasis on the role of risk appetite in signalling financial crises, we now see an increasing interest in its fluctuations. Analysing the interaction between risk appetite and financial market developments suggests that risk appetite measurements convey useful signals. The implications of risk appetite analysis are of great relevance to the real estate investment environment.

A plethora of measures for risk appetite are used routinely by markets. In the financial press, judgments on investors' willingness to bear more risk are drawn from elementary market information such as growth in emerging markets bond funds, direct investments in hedge funds, M&A activity, interest in high-yielding bonds, and demand for gold or Swiss francs. There are other individual raw series used to estimate changes in investors' perception of risk. These include the VIX volatility index; implied volatility in major currencies; a variety of bond, credit, and swap spreads; and survey and confidence indices. By aggregating these individual series, major financial institutions have created several general types of risk appetite indicators. More advanced work constructs indicators based on CAPM-type models and uses options markets data and implied volatilities. It compares risk-neutral probabilities with investors' subjective probabilities to refer to a few research methods for this family of indicators.

Risk appetite in real estate can be analysed and measured within this broader context, allowing for the idiosyncrasies of real estate. For example, several techniques cannot be applied to direct real estate due to the lack of implied prices from options and high frequency data. But as is clear from the brief discussion above, volatility is key in the construction of risk appetite measures. Further, a family of methodologies utilises and links volatility estimates with price variations and expected returns to construct risk appetite indicators. Based on this line of approach and utilising PPR's performance data from 35 European office markets, we have constructed an index for property risk appetite (IPRA) for offices. This indicator is shown in figure 1 over the past three years.

Based on existing practices, the index is designed to include values between -100 and 100. Some subjective classification can be made. If the index falls in the region of between -20 and 20, we can consider investors risk neutral. Readings between 20 to 50 should indicate moderate to good levels of risk appetite. On the other hand the range -50 to -20 should point to a significantly reduced risk appetite. Estimates lower than -50 and higher than 50 should be taken to show major reductions in risk appetite and major risk appetite, respectively.

The IPRA denotes risk aversion at the pan-European level until Q4 2009, which is consistent with macroeconomic uncertainties and the real estate market downturn that prevailed at that time. It then takes a sharp turn in the space of a quarter and moves into a risk-neutral position in Q1 2010, the likely result of a sudden rebound in positive sentiment in certain European markets. Throughout 2010 it implies good appetite for risk, which is predicted to continue into 2011. The index readings in 2010 correspond to the rise in liquidity in Europe. Of course, the yield compression from the fourth quarter or even the third quarter of 2009 in some markets would signal similar developments in markets. Yield movements are of course reflecting risk appetite but also the amount of risk that investors are willing to take on. However, APRI does provide a picture of the evolution of risk appetite and emerging trends despite the jump between Q4 2009 and Q1 2010 that one would have expected to be smoother (such oscillations are not uncommon in this category of indicators). As of Q2 2009 we can see a change in the trend and a tendency for lower negative risk appetite levels.

As is the case with more general risk appetite indices, we augment APRI with more information. We consider the time-varying volatility of office returns. Time-varying volatility captures macroeconomic and financial market uncertainties that introduce nervousness in markets and result in heightened price volatility. The time-varying, or conditional volatility, which is the technical term, quantifies near future uncertainty given everything we have seen so far. Figure 2 shows our estimates for this measure of volatility.

There was a significant volatility rise in 2008 and in most of 2009, which increased risk premia and reduced investors' risk appetite. The volatility eased considerably by historical standards in 2010 and into 2011, according to our predictions, implying that the market can resume its appetite for risk if the only consideration is time-varying volatility.
Incorporating this volatility measure into IPRA, we derive a more generalised index, which is shown in figure 3. It should be noted that unlike IPRA, the risk appetite values in figure 3 could only be interpreted in relation to IPRA's historical evolution and a long-term average value.

The generalised IPRA also shows strong negative risk appetite in 2009 but a gradual improvement in this sentiment from mid-2009, pointing to a switch in the mood. As was the case with IPRA, its generalised version points to a rise in 2010 and strong risk appetite at the end of 2010 and into 2011.

The readings of the risk appetite indices do imply good liquidity levels for 2011. Whether levels will move above those in 2010, as markets currently expect, depends on whether investors will seek greater amounts of risk given their sustained level of risk appetite. This could be the case, since risk appetite at the beginning of 2011 remains strong. Liquidity at the prime end is obviously maintained and will be extended to more prime centres. With yields for prime assets too competitive in the most liquid locations, focus will shift to opportunities in near-prime and even secondary assets across a broader geographical range.

It is apparent that the IPRA and any risk indicator that uses market-specific information will vary by market and sector. We should also note that a sustained strong risk appetite mightresult in risky positions and aggressive pricing; hence it is appropriate to see risk appetite readings returning to some kind of equilibrium and sustainable value.

Sotiris Tsolacos is director of -European research, Property and Portfolio Research