Commercial Real Estate Returns

In the commercial real estate market, which is perceived to be relatively inefficient, investors have comparative advantages; hence there are significant costs to diversification. This paper presents for the first time a series of market (or quasi-market) returns for a large data base. This data base is believed to be the most complete commercial real estate data base yet constructed. The paper empirically evaluates the benefits of diversification along various dimensions within the commercial real estate opportunity set. The analysis confirms certain aspects of prior work concerning inflation protection and diversification opportunities while concluding that even investment grade real estate investments are heterogeneous assets.     

Real Estate in an ALM Framework: The Case of Fair Value Accounting

This study examines the liability hedging characteristics of both direct and indirect real estate with the advent of fair value accounting obligations for pension funds. We explicitly model pension obligations as being subject to interest and inflation risk to analyze the ability of real estate investments in hedging the fair value of pension liabilities and to quantify its role in an asset liability management (ALM) portfolio. We find that the portfolio composition differs depending on the definition of liability return. When liability returns solely follow actuarial changes, the mean‐variance efficient portfolio allocations toward direct real estate and fixed income decrease compared to the asset‐only optimization. When accounting for nominal liability obligations, real estate offers hedging benefits against interest rates for short holding periods but not for long‐term institutional portfolios. The inclusion of inflation risk renders a limited role for direct real estate in an ALM portfolio, while indirect real estate obtains no allocation. Inflation is at the heart of the discrepancy between reported and predicted pension plan allocations. Once accounting for inflation, the projected allocations come close to reported ones.     

The Role of Real Estate in the Portfolio Allocation Process

This study explores the role of direct real estate investment in a portfolio context incorporating the real estate imperfections of indivisible assets and no short sales. Mean-variance efficient portfolios are calculated using Treasury-bills, bond and equity indices together with cash flows and appraised values from a set of twenty-two properties having an aggregate appraised value of $336 million. Real estate diversification benefits are shown to be the greatest with smaller properties and are most advantageous at higher target levels of return. The study suggests that a 9% allocation to real estate is optimal, rather than the 20% figure suggested in other studies.     

Portfolio Considerations in the Valuation of Real Estate

When a real asset rises in price faster than inflation (as real estate did in the late 1970s) and rises significantly in price over an extended period (as real estate has done for the last decade and one-half), it concerns valuation and investment professionals who fear about it being over-valued. One of the reasons for such price performance may be an increase in demand due to the portfolio characteristics of the asset during the period of time in question. For real estate this means the proportion included in optimal portfolios should be significant and increasing as individual tax rates increase in an environment of increasing average tax rates.
This study uses six tax brackets (0%, 10%, 20%, 30%, 40%, 50%) and portfolios consisting of three traditional assets (NYSE common stocks, corporate bonds and small stocks) plus three types of real estate (residential, business and farmland) to demonstrate that this is what has transpired in the real estate markets. Optimal portfolio weights are derived for each asset for after-tax portfolios. Real estate in general and residential real estate especially increased as a proportion of the optimal after-tax portfolio as individual tax rates increased. Other studies are used to demonstrate an environment of increasing average tax rates.     

Currency Swaps and International Real Estate Investment

This paper examines the efficacy of currency swaps as a hedging mechanism for the exchange rate risk associated with foreign investment in real estate. Earlier studies have concentrated on short-term hedging instruments such as options and forward contracts. Currency swaps are better suited for use on investments with long-term holding periods such as real estate. The findings indicate that, although hedging United States real estate investments with currency swaps suppresses most of the risk induced by currency instability, the improvements are insufficient to produce diversification gains for foreign investors in the context of mean-variance portfolio performance.     

Privately Versus Publicly Held Asset Investment Performance

Classic asset pricing is problematic as a method to assess privately held asset investment performance. We propose an alternative approach that involves adjusting the characteristics of assets constituting an index or portfolio to match the asset characteristics of a reference index or portfolio. This approach is applied to commercial real estate, where we create an index of REIT returns to compare to the NCREIF index. To enhance comparability, return indices are adjusted for partial-year financial data, leverage, asset mix and fees. Adjusted results over a 1980–1998 sample period show general convergence between the indices, although an annual return difference of over three percentage points remains in favor of public market asset ownership. Possible causes of the investment performance gap include liquidity and geography as missing risk factor adjustments, an unrepresentative sample period, and the form in which commercial real estate assets are held.     

The Predictability of International Real Estate Markets, Exchange Rate Risks and Diversification Consequences

International real estate related securities are investigated to see whether they offer any incremental diversification benefits over foreign stocks using mean-variance analysis together with a multifactor latent variable model. Diversification benefits are found to be primarily driven by unanticipated returns which are partially driven by changes in exchange rate risk. Although exchange rate risk accounts for a larger portion of the return fluctuation in real estate related securities relative to common stocks, international real estate securities provide some incremental diversification benefits over common stocks even if currency risks are hedged.     

Time and Risk Diversification in Real Estate Investments: Assessing the Ex Post Economic Value

Welfare gains to long-horizon investors may derive from time diversification that exploits nonzero intertemporal return correlations associated with predictable returns. Real estate may thus become more desirable if its returns are negatively serially correlated. While it could be important for long-horizon investors, time diversification has been mostly investigated in asset menus without real estate and focusing on in-sample experiments. This article evaluates, ex post, the out-of-sample gains from diversification when equity real estate investment trusts (REITs) belong to the investment opportunity set. We find that diversification into REITs increases both the Sharpe ratio and the certainty equivalent of wealth for all investment horizons and for both classical and Bayesian (who account for parameter uncertainty) investors. The increases in Sharpe ratios are often statistically significant. However, the out-of-sample average Sharpe ratio and realized expected utility of long-horizon portfolios are frequently lower than that of a one-period portfolio, which casts doubt on the value of time diversification.     

Real Estate Investment Acquisition Rules for Life Insurance Companies and Pension Funds: A Survey

Real estate comprises the major wealth of the United States as well as the world. Life insurance companies and pension funds are rapidly becoming major investors in real estate due to their large portfolios and annual cash inflows. Aggregate inflows of life insurance companies and pension funds are estimated to be about 150 billion dollars per year. Increasing amounts of these funds are believed to be going into real estate investments. This study surveys life insurance companies and pension managers on all facets of their real estate investments. The survey covers real estate portfolio size and type, portfolio composition, investment by property type, international investments, before-tax analysis, after-tax analysis, diversification strategies, computer usage, holding period assumptions and criteria for obtaining mortgages, equity positions and construction loans. The results of this study are then compared and contrasted with previous studies.     

Real Estate Returns: A Comparison with Other Investments

Real estate returns, measured unleveraged, have been between those of stocks and bonds over 1960–1982. Due to appraisal smoothing and imperfect marketability, one must be careful about directly comparing measured real estate returns with those on other assets. It is likely, however, that low correlations with stocks and bonds make real estate a diversification opportunity for traditional portfolio managers. In addition, the issue of how various assets are priced is addressed. While stocks are priced primarily on market or beta risk, and bonds are priced primarily on interest rate and default risk, the real estate pricing mechanism includes residual risk and non-risk factors such as taxes, marketability costs and information costs.     

The Composition of the Market Portfolio and Real Estate Investment Performance

This study investigates whether the composition of the market portfolio leads to different inferences on real estate performance. As a point of departure, this paper first explores whether the omission of assets in a market proxy leads to a biased measurement of investment performance. The study finds that ranking investment performance is not meaningless even though investment performance is inaccurately measured. Furthermore, the composition of the market proxy does not necessarily lead to different inferences on real estate investment performance although superior real estate investment performance arises from the omitted asset phenomenon and also from smoothing bias in general.     

Diversification Categories in Investment Real Estate

This paper continues previous work evaluating the benefits of diversification and analyzes the various dimensions within the commercial real estate opportunity set. The database is large and extends through the 1982 downturn in property values. Due to the low levels of systematic risk, current distinctions by region and property type make little sense in a world of costly diversification. More exacting categories combining property type, SMSA growth rate and lease maturity offer promise for more efficient diversification within the real estate portfolio.     

On the Portfolio Properties of Real Estate in Good Times and Bad Times1

Motivated by the theoretical results on strategic asset allocation, we examine the gains in portfolio performance when investors diversify into different asset classes, with particular focus on the timeliness of such gains. Although the various asset classes we analyze yield significant gains in portfolio performance, even in the presence of short‐sales constraints, the timeliness of the gains differs considerably across the asset classes. Our key result is that real estate and commodities and precious metals are the two asset classes that deliver portfolio gains when consumption growth is low and/or volatile, that is, when investors really care for such benefits. Our analysis highlights an important metric by which to judge the attractiveness of an asset class in a portfolio context, namely the timeliness of the gains in portfolio performance. Further, our results on the performance of real estate in both good times and bad times suggest that the typical institutional allocation to real estate may underweight the role of the asset class in a diversified portfolio context.     

Institutional common ownership and firm value: Evidence from real estate investment trusts

This paper contributes to the ongoing debate about whether and how institutional common ownership (ICO) affects firm behavior. Using a sample of equity real estate investment trusts (REITs), which provide significant advantages for isolating a monitoring channel, we find a robust and positive relation between ICO and REIT firm value. The positive relation between ICO and firm value is driven mainly by motivated investors and becomes stronger when we construct our ICO measures using blockholdings. Our difference‐in‐differences analysis, using mergers between institutional investors, suggests a causal relation exists between ICO and firm value. After investigating various channels through which ICO could affect firm behavior, we conclude that asset allocation decisions and performance are the most plausible explanations. Our finding that the monitoring associated with ICO aids managers in their portfolio disposition strategies further supports this conclusion. This enhanced monitoring leads to increased property portfolio returns, as well as more geographic diversification.     

Continental Factors in International Real Estate Returns

This paper examines the extent to which real estate returns are driven by continental factors. This subject is relevant for determining the country allocation of international real estate portfolios. If returns are driven by a continental factor, investors should look for diversification opportunities outside their own continent. This paper finds strong continental factors in North America and especially in the United States. For the Asia–Pacific region, real estate returns are not driven by a continental factor. The results suggest that, for European, North American and Asia—Pacific real estate portfolio managers, the Asia—Pacific region provides attractive international diversification opportunities.     

A Comparison of the Recent Performance of Publicly Traded Real Property Portfolios and Common Stock

In this study we compare the returns earned by investments in publicly traded limited partnerships (PTLPs), finite life equity REITs, and traditional equity REITs with those resulting from investing in common stocks (proxied by closed-end mutual funds). Performance comparisons are made using generalized stochastic dominance (GSD). This tool avoids the joint hypothesis problem that arises when an asset pricing model is used as a performance benchmark. The results of the analysis indicate that the performance of the closed-end mutual funds was preferred to that of the individual equity REITs (both traditional and finite life) and PTLP securities by a wide array of risk-averse investors. This result was most pronounced following the passage of the Tax Reform Act of 1986 which severely restricted the tax deductibility of real estate losses. When the equity REITs were combined into portfolios, their performance dominated the mutual funds during the 1980–85 period. Further, the PTLP portfolio returns were preferred to several of the mutual funds even in the post-1985 period. These findings reflect the fact that the securitized real property portfolios studied are not as well diversified as mutual funds. However, the mutual funds remained the dominant investment alternative in the post-1986 period.     

Why Agency Costs Explain Diversification Discounts

We study diversificsation within the real estate industry because of its relative transparency: portfolio management of assets with well-defined market prices. Diversification is over property types and geographical regions. The major cause of the diversification discount is not diversification per se but anticipated costs due to rent dissipation in future diversifying acquisitions. Firms expected to pursue nonfocusing strategies do indeed diversify more, are valued ex ante at a 20% discount over firms anticipated to follow a focusing strategy, are predominantly privately controlled and use dual-class shares extensively. The ex ante diversification discount is, therefore, a measure of agency costs.     

Real Estate for the Long Term: The Effect of Return Predictability on Long-Horizon Allocations

We examine how the predictability of real estate returns affects the risk of, and optimal allocations to, real estate for investors of differing investment horizons. Returns to direct real estate are mean reverting, and risk decreases with horizon. This is driven by a tendency for property transaction prices to overshoot inflation. Mean reversion in real estate returns is weaker than that of equities, resulting in real estate having similar risk to equities for long-term investors. However, optimal portfolios have large allocations to direct real estate at all horizons, and the allocation increases with horizon. Finally, we find that real estate investment trusts are a redundant asset class for investors with access to direct real estate as an asset class, but they do have a role in optimal allocations when direct property investment is not feasible.     

Real Estate in a Mixed‐Asset Portfolio: The Role of the Investment Horizon

In this article, three oft‐mentioned special characteristics of the real estate asset market—high transaction costs, marketing period risk and return predictability—are addressed in analyzing the role of U.K. commercial real estate investments in a mixed‐asset portfolio. Due to favorable horizon effects in risk and return, the allocation to real estate in a portfolio with stocks, bonds and cash increases strongly with the investment horizon. Examining the relative importance of return predictability, transaction costs and marketing period risk for the optimal allocation to real estate, the article finds that the consideration of return predictability is very important, except for short‐term horizons. Accounting for transaction costs is crucial for short‐ and medium‐term investors. Marketing period risk appears to be negligible. Traditional mean‐variance analysis—that is, ignoring return predictability, transaction costs and marketing period risk—can be very misleading.     

Institutional Investors' Preferences for REIT Stocks

This article investigates the determinants of real estate investment trusts (REIT) portfolio investment and institutional REIT ownership using multivariate Tobit regressions. We contend that many institutional investors take larger positions in more liquid assets like REIT stocks, as compared with private real estate equities, because of liquidity considerations. Consistent with this contention, we find that liquidity constraints are significantly related to REIT portfolio investment by institutional investors. We also find that institutional investors have different preferences for REIT stocks than do other investors; they generally prefer larger, more liquid REIT stocks.