DIVERSIFICATION IN THE REAL ESTATE PORTFOLIO

This study investigates primarily the relationship between portfolio size and the reduction of return variation in real estate portfolios and attempts to provide some notion of what represents an “adequate” level of naive diversification. The study also examines the proportional components of the total risk in real estate investment. The results provide information on the relative percentage of total risk accounted for by systematic or “market” factors.     

Diversification Issues in Real Estate Investment

Real estate asset management has been and will continue to be a topic of great interest. Specifically, does real estate warrant inclusion in an efficient portfolio? And if so, how much should be invested in real estate? This article reviews the extant literature in the area of real estate diversification and helps identify the reasons that there exists so much divergence in the answer to the question, “How much in real estate?” Moreover, diversification as it relates to real estate is discussed in reference to both mixed-asset portfolios and for diversification within the real estate asset class. Directions for future research are also discussed.     

International diversification with securitized real estate and the veiling glare from currency risk

This paper analyzes diversification benefits from international securitized real estate in a mixed-asset context. We apply regression-based mean-variance efficiency tests, conditional on currency-unhedged and fully hedged portfolios to account for systematic foreign exchange movements. From the perspective of a US investor, it is shown that, first, international diversification is superior to a US mixed-asset portfolio, second, adding international real estate to an already internationally diversified stock and bond portfolio results in a further significant improvement of the risk-return trade-off and, third, considering unhedged international assets could lead to biased asset allocation decisions not realizing the true diversification benefits from international assets.     

Dynamics of Private and Public Real Estate Markets

Using five assets (T-bills, bonds, stocks, and both public and private real estate), this study investigates how cointegration of capital markets affects the dynamics of public and private real estate markets. The results show that the price indices of the five assets are nonstationary and cointegrated. Some implications for the long-term equilibrium relationship for portfolio diversification, price discovery and prediction are discussed. In a Granger causality framework, error-correction augmented VAR models (VECM) and unrestricted VAR models are compared with respect to the conclusion regarding the interaction between public and private real estate returns. VECM is also shown to improve the prediction of private real estate returns relative to an unrestricted VAR model. These results raise questions about previous research studies regarding the dynamics between public and private real estate returns. It is shown that the long-term equilibrium relationship establishes a feedback between the two real estate markets, but the private market seems to informationally lead the public one. Possible explanations are also explored.     

Dynamic Interactions Between Private and Public Real Estate Markets: Some International Evidence

This study evaluates long-run relationships and short-run linkages between the private (unsecuritized) and the public (securitized) real estate markets of Australia, Netherlands, United Kingdom and the United States. Results indicate the existence of long-run relationships between the public and private real estate markets of each of the countries under consideration. This implies that for all countries, investors would not have realized long-term portfolio diversification benefits from allocating funds in both the private and public real estate markets since these assets are substitutable over the long run. Short-run analyses also reveal significant causal relationships between private and public markets of all countries under consideration. As expected, it was found that price discovery occurred in the public real estate market in that it leads but is not led by its private real estate market counterpart.     

International Diversification Strategies for Direct Real Estate

This paper will disentangle the performance of international real estate into property type performance and region selection. This helps to create an international diversification strategy for direct real estate. We use constrained cross-section regression with dummy variables for regions and property types to measure the best risk reducer. We analyze the impact of currency changes on total returns by looking at a hedged and un-hedged portfolio, both stock and equally weighted. The findings show that geographic factors have the largest influence on the volatility of international real estate returns. The average variance of the regional effects is higher than the property type effects and therefore the regional effects have a higher influence on the variation of the total portfolio. However, the regional effects are less stable through time, compared with the variance and correlation of the property type effects. Also the property type effect seems to become a more important factor for the return over time, especially when the return is expressed in local currency.     

The Role of Real Estate in an Institutional Investor's Portfolio Revisited

Many papers have recently pointed out that institutional investors allocate only a very small fraction of their portfolio to real estate, much smaller than theory would dictate. This raises the question, are institutional investors underinvested in real estate equities? Or do we simply have the wrong priors? This paper is an attempt to provide some new insights into this asset allocation paradox. The key conclusions of the paper are several: First, unlike other assets, it would appear that real estate, and real estate diversification, pays off at the very time when the benefits are most needed, that is, when consumption growth opportunities are low. Second, real estate returns are predictable. In fact, the amount of predictability in real estate returns appears to be about the same as in stock returns. Third, real estate performs well in an asset-liability framework. Fourth, the chance of experiencing a large loss on real estate over a long horizon is quite small. We also report here that private sector commercial real estate investments represent between 6 and 12 percent of investable wealth in the United States. Thus, it follows (if one believes the capital asset pricing model) that if institutional investors were to invest more in real estate (up to 12 percent of their assets), they should be able to eliminate nonmarket or unique risk. All of this leaves us a bit dumbfounded as to why institutional investors hold only between 2 and 3 percent of their assets in real estate.     

Global Property Market Diversification

This paper examines global diversification benefits provided by developed property markets over 1992–2007. We employ a cointegration methodology, invariant to pair-wise correlational instability plaguing MPT approaches, to investigate regional and country property market diversification benefits for U.S. domiciled global real estate investors. We show, theoretically and empirically, the cointegration procedure aptly identifies markets integrated by common trends that mitigate diversification potential. We show global property markets are interregionally independent but find intraregional market cointegration. A portfolio of markets independent of cointegrating relationships performs best during the period but is insufficiently diversified relative to a cointegrated portfolio. Independent country markets do account for the bulk of global property diversification gains but cointegrated markets, particularly from the North American and Asia Pacific regions, retain some diversifying qualities. We also show cointegrated markets converge toward benchmark characteristics, reducing their attraction as portfolio candidates.     

Diversification Benefits of Japanese Real Estate Over the Last Four Decades

This paper studies the benefits of diversifying into real estate and other assets that typify the wealth held by Japanese investors. We examine movements in mean variance frontiers by employing spanning tests to assess the statistical significance of frontier shifts. We also investigate the impact of shifts in mean variance frontiers before and after the precipitous decline in Japanese real estate and stock market values that began in 1990. Spanning tests show that real estate, short and long-term bonds, and Japanese equity provide significant diversification benefits. We find that mean variance frontiers shift after 1990. Statistically significant shifts are also economically important as measured by Sharpe ratio changes. Although significant, the portfolio weights on Japanese real estate are relatively small compared to their composition found in surveys of Japanese household wealth.     

Commercial Real Estate Return Performance: A Cross-Country Analysis

This paper investigates the return performance of publicly traded real estate companies. The analysis spans the 1984–1999 time period and includes return data on over 600 companies in 28 countries. The return data reveal a substantial amount of variation in mean real estate returns and standard deviations across countries. Moreover, standard Treynor ratios, which scale country excess returns by the estimated beta on the world wealth portfolio, also reveal substantial variation across countries in excess real estate returns per unit of systematic risk. However, when we estimate Jensens alphas using both single and multifactor specifications, we detect little evidence of abnormal, risk-adjusted returns at the country level. We do, however, find evidence of a strong world-wide factor in international real estate returns. Furthermore, even after controlling for the effects of world-wide systematic risk, an orthogonalized country-specific factor is highly significant. This suggests that real estate securities may provide international diversification opportunities.     

Harmful diversification: Evidence from alternative investments

Alternative assets have become as important as equities and fixed income in the portfolios of major investors, and so their diversification properties are also important. However, adding five alternative assets (real estate, commodities, hedge funds, emerging markets and private equity) to equity and bond portfolios is shown to be harmful for US investors. We use 19 portfolio models, in conjunction with dummy variable regression, to demonstrate this harm over the 1997–2015 period. This finding is robust to different estimation periods, risk aversion levels, and the use of two regimes. Harmful diversification into alternatives is not primarily due to transactions costs or non-normality, but to estimation risk. This is larger for alternative assets, particularly during the credit crisis which accounts for the harmful diversification of real estate, private equity and emerging markets. Diversification into commodities, and to a lesser extent hedge funds, remains harmful even when the credit crisis is excluded.     

Long-Term Co-Memories and Short-Run Adjustment: Securitized Real Estate and Stock Markets

This study considers whether securitized real estate and stock markets have long-term co-memories and implications for short-term adjustment. Our results offer reasonable support for fractional cointegration (characteristic of a long memory process) between securitized real estate price, stock market price and key macroeconomic factors in some economies. The implication is that where fractional cointegration prevails, securitized real estate and common stocks are substitutable assets over the long run and these assets may not be held together in a portfolio for diversification purpose. Furthermore, short-run analysis indicates that the speed of adjustment towards the long-run equilibrium is faster for fractional integrated vector error correction model (FIVECM) than VECM as the former incorporates a long history of past cointegration residuals. Additional comparisons of the two models’ forecasting accuracy show that incorporating fractional cointegration in a VECM model improves the forecasting performance over conventional VECM models. Our results reinforce the notion that cointegration, fractional cointegration and short-run adjustment dynamics are important in understanding market integration/segmentation.     

International Real Estate Mutual Fund Performance: Diversification or Costly Information?

We investigate the net effect between diversification benefit and information cost of international real estate mutual funds from three dimensions: whether investors can benefit from investing in international real estate mutual funds, whether managers of international real estate mutual funds possess superior market knowledge and timing abilities, and whether investors are motivated by returns or diversification. Our findings are threefold. First, the results show that international real estate mutual funds perform better and are less risky than domestic real estate mutual funds before Jun 2007. That is, diversification benefits outweigh the information costs, and investors therefore gain from investing in international real estate mutual funds. However, the benefit is reduced because of the economic shock of sub-prime financial crisis. Second, on average, neither international mutual fund managers nor domestic mutual fund managers possess market timing abilities. Finally, we find that fund flows are driven by investors’ return-chasing behaviors and fund size, but not by diversification purpose.     

Risk and return in residential spatial markets: An empiric and theoretic model

The paper is concerned with price and rent fluctuations in predominantly owner-occupied residental real estate. It presents the owner-occupier household as a housing consumer as well as an investor. It conjectures that since risk and return are known to be positively related in financial markets, they might also be thus related in residential real estate markets. If that is so, neighborhoods that are known to yield high returns will be the ones less price and rent stable than low yielding ones.The Capital Asset Pricing Model is not helpful in explaining a possible risk/return relationship in housing markets. Its major assumption about portfolio diversification is contrary to the nature of owner-occupied residential real estate. An owner occupier household, by definition, holds one unit of the asset and acts simultaneously as an investor and consumer of housing. For the capital market investor, investment and consumption decisions are separable. Therefore, a new theoretical model of consumer choice is proposed. Tel-Aviv price and rent data during a volatile market period are used for testing the main risk/return conjecture as well as other related hypotheses stemming from the model. The findings lend support to the conjecture and shed light on possible spatial determinants of owners' risk.     

The Anatomy of Public and Private Real Estate Return Premia

Market-wide, stock market specific, and real estate market specific risk – what kind of risk and to which extent drives the returns of listed real estate? Based on a structural asset pricing model calibrated to the empirical data in the U.S., we show that at least two thirds of the risk premium of listed real estate are driven by the same factors as direct real estate. Our results shed new light on the risk-characteristics of listed real estate returns and are of high interest for academics, regulators, and portfolio managers alike.     

Are REITs real estate? Evidence from international sector level data

The aim of this study is to examine whether securitized real estate returns reflect direct real estate returns or general stock market returns using international data for the U.S., U.K., and Australia. In contrast to previous research, which has generally relied on overall real estate market indices and neglected the potential long-term dynamics, our econometric evaluation is based on sector level data and caters for both the short-term and long-term dynamics of the assets as well as for the lack of leverage in the direct real estate indices. In addition to the real estate and stock market indices, the analysis includes a number of fundamental variables that are expected to influence real estate and stock returns significantly. We estimate vector error-correction models and investigate the forecast error variance decompositions and impulse responses of the assets. Both the variance decompositions and impulse responses suggest that the long-run REIT market performance is much more closely related to the direct real estate market than to the general stock market. Consequently, REITs and direct real estate should be relatively good substitutes in a long-horizon investment portfolio. The results are of relevance regarding the relationship between public and private markets in general, as the ‘duality’ of the real estate markets offers an opportunity to test whether and how closely securitized asset returns reflect the performance of underlying private assets. The study also includes implications concerning the recent financial crisis.     

Real estate returns,money and fiscal deficits: Is the real estate market efficient?

This research examines the causal relationship between several financial variables and a portfolio of real estate returns using monthly data from January 1965 to December 1986. The empirical analysis is based on multivariate Granger-causality tests in conjunction with Akaike's final prediction error criterion. The results indicate that measures approximating monetary policy and market returns play an important role in causing changes in real estate returns. In particular, our findings suggest that base money and market returns have had significant lagged effects on current real estate returns.     

<Emphasis Type="Italic">K</Emphasis>-fold cross validation performance comparisons of six naive portfolio selection rules: how naive can you be and still have successful out-of-sample portfolio performance?

Recent research reports that optimal portfolio selection models often perform worse than equal-weight naive diversification in out-of-sample testing. This paper extends this line of inquiry by comparing the out-of-sample performance of the equal-weight naive strategy to the out-of-sample performance of five alternative naive strategies, each of which derives from a simple heuristic that does not require any optimization. Out-of-sample portfolio performance is assessed by mean, standard deviation, skewness, and Sharpe ratio; k-fold cross validation is used as the out-of-sample testing mechanism. The results indicate that the proposed naive heuristic rules exhibit strong out-of-sample performance, in most cases superior to the equal-weight naive strategy. These findings are consequential for at least two reasons: first, if these simple heuristic-based rules outperform the equal-weight naive strategy, then by transitivity they can outperform the mean–variance- and shortfall-optimal portfolio rules that have been shown in the literature to be inferior to the equal-weight naive rule, which further emphasizes the out-of-sample fragility of “optimal” methods; and second, among naive diversification strategies, some appear more robust in out-of-sample testing than others, hence the proposed methods may be useful when forming mixed portfolio selection models wherein a naive strategy is combined with an optimal strategy to improve performance.     

Spatial Statistics Applied to Commercial Real Estate

Portfolio theory shows that diversification can enhance the risk-return trade-off. This study uses the absolute location of commercial real estate property along with spatial statistics to address the inherent problem of determining geographical diversification based upon a set of economic and property-specific attributes, some of which are unobservable or must be proxied with noise. We find that commercial real estate portfolios exhibit statistically significant spatial correlation at distances ranging from adjacent zip codes to neighboring metropolitan areas. Given the common structure of dependence found in the data series, we discuss feasible strategies for obtaining diversification within direct-investment real estate portfolios.