Integrating Illiquid Assets into the Portfolio Decision Process

We consider the issues associated with modeling the decision to invest in an illiquid asset, such as real estate, over an extended period of time. Markets for illiquid assets tend to display certain characteristics: for example, significant time‐till‐sale and correlation in the rates of return over time. More importantly, as the liquidity of a market cannot be an issue if an investor never needs to liquidate an asset, we focus on how the liquidity of a market interacts with an individual's uncertain need to liquidate. We show that the optimal strategy is state contingent, if possible. We also show that the penalty associated with an illiquid investment depends on the characteristics of other assets being held in the portfolio, on the characteristics of liquidity shocks and on the interaction between time and behavior. We show that borrowing to pay for a liquidity shock cannot overcome all of the costs of owning an illiquid asset. In contrast, borrowing at t = 0 benefits from the complementarity in the assets. In a simpler model, we show that the portfolio perspective makes illiquid assets more valuable to an investor with a longer time horizon.     

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.     

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.     

Geographic Portfolio Allocations,Property Selection and Performance Attribution in Public and Private Real Estate Markets

This article examines the effects of geographic portfolio concentrations on the return performance of U.S. public real estate investment trusts versus private commercial real estate over the 1996–2013 time period. Adjusting private market returns for differences in geographic concentrations with public markets, we find that core private market performance falls. Using return performance attribution analysis, we find that the geographic allocation effect constitutes only a small portion of the total return difference between listed and private market returns, whereas individual property selection within geographic locations explains, in part, the documented outperformance of listed versus private real estate market returns.     

Temporal Aggregation in Real Estate Return Indices

Temporal aggregation is defined as the use of spot valuations of properties occuring over an interval of time to impute the spot value of a property or of a real estate value index as of a single point in time. Temporal aggregation may characterize not only appraisal-based indices but also indices based directly on transaction prices, such as the National Real Estate Index (NREI) and regression-based indices such as hedonic or repeat-sales indices. This paper analyzes the effect of temporal aggregation on the smoothing of the time series second moments in the resulting real estate return index. Assuming true spot returns are uncorrelated, temporal aggregation-induced smoothing will cause the empirically observed real estate index to understate the own-variance by one-third and the beta by one-half. This amount of bias in the second moments can have major implications for the real estate share in an optimal portfolio. Thus, empirical-based investment analysis could be led astray by smoothing even if the real estate return index is "transaction-based" rather than "appraisal-based."     

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.     

Controlling for the Impact of Variable Liquidity in Commercial Real Estate Price Indices

Liquidity in private asset markets is notoriously variable over time. Therefore, indices of changes in market value that are based on asset transaction prices will systematically reflect intertemporal differences in the ease of selling a property. We define and develop a concept of "constant-liquidity value" in the context of a model that is characterized by pro-cyclical volume of trading. We then present an econometric model that allows for estimation of both a standard transaction-based price index and a constant-liquidity index. Our application to the NCREIF database reveals that, in the case of institutional commercial real estate investment, constant-liquidity values tend to lead transaction-based and appraisal-based indices in time, and also to display greater volatility and cycle amplitude. The differences can be significant for strategic investment policy viewed from a mean-variance portfolio optimization perspective.     

The Substitutability of Real Estate Assets

This paper investigates the degree of substitutability between securitized real estate assets and real estate assets whose prices are appraisal-based. Given the insensitivity of unsecuritized asset's returns to the returns on stock market indices, equilibrium asset pricing models cannot be used to compare these two avenues of investment. Two assets are deemed substitutable if the information sets underlying unbiased, minimum error variance estimates of their pricing parameters are identical. The empirical evidence shows that the prices of the transactions-based assets—real estate investment trusts and the stock price index of the home building industry—follow a random walk while the prices of the appraisal-based assets—FRC/NCREIF indices—do not. The variance decompositions of the vector autoregressions also show that the level of economic activity helps predict the price indices of appraisal-based assets while the stock market index and the term structure of interest rates are better predictors of the prices of transactions-based assets     

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.     

The Performance of Commercial Mortgages

This study examines the return characteristics of a large, well-diversified commercial mortgage portfolio. Mortgage-specific cash-flow histories are constructed for 2,480 loans originated over the period 1974 through 1990, and a contingent-claims approach to pricing risky debt is used to estimate inter-temporal market values. Quarterly holding-period returns are compared across selected mortgage groups and to alternate asset classes. Our findings suggest that both mortgage returns and volatility of return are comparable to those of other forms of fixed-income assets over the study period. Implied property price volatility is found to average 17%, a result significantly higher than reported in earlier studies. While mortgage returns are found to vary by property type and region of origin, cross correlation of returns is found to be high, illustrating the systematic effect of interest rates on the performance of commercial mortgages over the period 1974 through 1990. However, an increase in credit risk in the latter years of the study suggests that diversification may be a worthwhile objective for holders of these assets. We do not find evidence to suggest that abnormal returns were earned on commercial mortgage portfolios over the study period.     

Transactions-Driven Commercial Real Estate Returns: The Panacea to Asset Allocation Models?

A transactions-driven commercial real estate return series is generated in this study to determine whether the reliance on appraised values in the estimation of real estate returns is the source of the reported underpricing of real estate relative to stocks, bonds, and bills when analyzed in a traditional mean-variance setting. The reported underpricing of commercial real estate would be rational if transactions-driven returns exhibit more variance than appraisal-driven returns. While we find that transactions-driven real estate returns have greater variance than appraisal-driven returns for individual properties, most of the individual property risk is idiosyncratic and diversified away at the portfolio level. Real estate continues to be a dominate asset class in mean-variance allocation models even when represented with transactions-driven indices.¹     

Real Estate Investment Funds: Performance and Portfolio Considerations

This paper presents the results of a study dealing with a number of issues regarding real estate investment. Utilizing a data set consisting of returns from two of the oldest, continuously operating commingled real estate funds (CREFs), questions relative to investment performance, inflation hedging attributes and diversification benefits are addressed. The methodology used in exploring these issues are variants of the traditional capital asset pricing model (CAPM), extended to consider uncertain inflation (CAPMUI) and an arbitrage pricing model in which real estate performance is judged relative to a more inclusive market index representing larger numbers of substitute investments. Finally, issues relative to portfolio performance are considered by constructing portfolios containing all possible combinations of real estate, stocks and bonds to assess the potential for diversification benefits and portfolio performance.     

Another Take on Real Estate's Role in Mixed‐Asset Portfolio Allocations

This article examines real estate's role in institutional mixed‐asset portfolios using both private‐ and public‐real estate indices, as a means of examining varying real estate‐related risk/return opportunities. In so doing, this article also examines the effects of: (1) increasing the investment horizon, (2) placing constraints on the maximum allocation to any one asset class, and (3) varying the risk preferences of investors. The empirical results suggest—using infinite‐horizon returns and all of the caveats that accompany such a perspective—that real estate allocations of approximately 10–15% of the mixed‐asset portfolio represent an upper bound for most investors. For those investors preferring low‐risk portfolios, (unlevered) private real estate is the vehicle serving this allocation preference; for those investors preferring high‐risk portfolios, public real estate (with its embedded leverage of 40–50%) is the vehicle serving this allocation preference—with such vehicles serving as substitutes for a variety of noncore real estate strategies. In some sense, the distinction between private and public real estate is more about the use of leverage. For those investors preferring moderate‐risk portfolios, an intermediate‐leverage approach seems optimal.     

Pension-Plan Real Estate Investment in an Asset–Liability Framework

This study explores the role of pension-plan real estate investment in an asset–liability framework. By assuming that the pension-plan manager wishes to have assets of at least equal value to the liabilities at all points in time, an asset selection process is derived which depends on both the asset's covariance with other assets and its covariance with the liability stream. We generally find real estate not to be highly correlated with pension-plan liabilities. This finding is of general interest, since it helps to explain why pension-plan real estate investment is extremely limited and much smaller than one would expect if pension-plan investors cared only about the mean and variance of the real return to their invested wealth.     

Estimating Returns on Commercial Real Estate: A New Methodology Using Latent-Variable Models

Despite their widespreao use as benchmarks of U.S. commercial real estate returns, indexes produced by the National Council of Real Estate Investment Fiduciaries (NCREIF) are subject to measurement problems that severely impair their ability to capture the true risk–return characteristics–especially volatility–of privately held commercial real estate. We utilize latent-variable statistical methods to estimate an alternative index of privately held (unsecuritized) commercial real estate returns. Latent-variable methods have been extensively applied in the behavioral sciences and, more recently, in finance and economics. Unlike factor analysis or other unconditional statistical approaches, latent variable models allow us to extract interpretable common information about unobserved private real estate returns using the information contained in various competing measures of returns that are measured with error. We find that our latent-variable real estate return series is approximately twice as volatile as the aggregate NCREIF total return index, but less than half as volatile as the NAREIT equity index. Overall, our results strongly support the use of latent-variable statistical models in the construction of return series for commercial real estate.     

Real Estate Returns and Risk with Heterogeneous Investors

This article develops a theoretical framework and formulates a unified risk metric that integrates both real estate price risk and uncertainty of time on market (TOM). We demonstrate that real estate sellers with different degrees of financial distress face not only different marketing period risks, but also receive different return distributions upon successful sales. The major findings of this article can be summarized as follows. First, we show that real estate return and risk, which account for both price and TOM risk, are investor specific, varying over investors with different financial circumstances and holding periods. Second, the traditional valuation of real estate return and risk, which is based solely on the return distribution of a successful sale without considering the uncertainty of TOM and the investor's financial circumstances, underestimates real estate risk and exaggerates real estate return. Third, our empirical applications in both residential and commercial real estate markets show that the Sharpe ratio estimated by the traditional approach is seriously overstated—to the largest extent for investors with high financial distress. In addition, we find that, given the typical 5‐ to 7‐year holding period for real estate, the Sharpe ratios estimated by integrating both price and TOM risk are much in line with the performance of financial assets. These findings can help to explain the apparent “risk‐premium puzzle” in real estate.     

A Note on the use of Appraisal Data in Indexes of Performance Measurement

This paper demonstrates that even when unbiased appraisals of market value are used in measuring the investment performance of real estate portfolios, a bias in the rate of return or index is present. Further, in the case where the appraisal errors are serially independent, the bias is always positive. The potential for bias in a standard rate of return formula is described. Some implications for portfolio formation and investment manager comparisons are discussed.     

Returns and Information Transmission Dynamics in Public and Private Real Estate Markets

This paper examines U.S. public and private commercial real estate returns at the aggregate level and by the four major property types over the 1994–2012 time period. Returns are carefully adjusted for differences between public and private markets in financial leverage, property type focus and management fees. Unconditionally, we find that passive portfolios of unlevered core real estate investment trusts (REITs) outperformed their private market benchmark by 49 basis points (annualized) over the 1994–2012 sample period. Our baseline vector autoregression results suggest that REIT returns do not embed additional commercial real‐estate‐specific information useful in predicting private market returns. These results strongly suggest that equity REIT returns react to fundamental (latent) asset pricing information more quickly than private market returns given their greater liquidity and price revelation. REITs therefore serve as a fundamental information transmission channel to private market returns when asset pricing variables are omitted.     

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.     

Public Versus Private Real Estate Equities: A More Refined, Long-Term Comparison

In this article we compare public and private real estate equities. In so doing, we control for three of the main differences between these investment alternatives: property-type mix, leverage and appraisal smoothing. With these two restated indices, we then run tests to determine in a statistical sense whether the restated means and volatilities of the two series were different from one another. The clear answer is that they were not. The results of the statistical tests combined with the fact that the average difference between the two (restated) return series has substantially narrowed (to approximately 60 basis points) in the more recent (1993–2001) period jointly suggest a seamless real estate market in which public- and private-market vehicles display a long-run synchronicity. This has important implications for portfolio management. First, public- and private-market vehicles ought to be viewed as offering investors a risk/return continuum of real estate investment opportunities. Second, while the "platform" did not matter in terms of observed return characteristics, the platform may matter with regard to liquidity, governance, transparency, control, executive compensation and so forth; an apparent clientele effect hints at these issues being valued differently by large and small investors.