Real Estate and Portfolio Theory Lecture Map – Review of Portfolio Management Theories Asset allocation using the efficient frontierImmunization and liability hedging – Role of Real Estate in an Investment Portfolio – Asset selection within the Real Estate A sset Class What do institutions want from their real estate investments? Is there a „best way‟ to select real estate investments?
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Frontier represents unique combinations of assets that optimizerisk adjusted returns
– i.e., optimal covariance between holdings in portfolio At each point along the Frontier, there are no “dominant”
portfolios – i.e., no portfolios that offer greater return given the risk level
Any other asset combinations either increase risk for same or lower returns, or decrease return for at least the same level of risk
Adding imperfectly correlated assets to a portfolio extends theefficient frontier to the NW, providing better reward to riskpayoffs – The lower the correlation, the greater the benefit of diversification
CAPM takes the risk adjusted return theory down to the assetlevel
If markets converge around risk/return expectations – themarket clearing price for assets – then only the relative risk of one asset versus others matters at the margin – Diversification should eliminate asset specific risk
– “Beta” management
Implies that all investors at any given risk level or return targetshould have basically the same assets in their portfolios at eachpoint along the curve
The mean variance asset allocation model suggests thatpension funds have been historically underweighting real estateand value stocks.
One theory is that these models ignore reinvestment risk.
– Suppose that expected rates of return on risky investmentsdecline.
– This causes asset prices to increase (which is good) butimplies that new investments will realize a lower rate of return (which is bad).
– Growth stocks tend to realize the highest returns in thesesituations, and thus provide the best hedge against areduction in reinvestment risk. Hence, growth stocksdeserve a higher allocation than implied by the mean
Where do REITs fit in: are they really a differentasset class than real estate? – Need to also ask whether REITs are different than other
value stocks. The high allocation to REITs in some studiesignore the substitution between REITs and other valuestocks.
At least REITs offer the ability to build a long termdata base with the mark - to – market characteristicsof stock and bond indices – Should improve the analysis of REIT covariances over time
Does Immunization Work?(or, Does it Really Make Any Difference
Which Approach You Use?)
Does this strategy makes sense for portfolios that wereseverely damaged in the bust? –
Significant number of pension funds today are underfunded – Evidenced by stress on Pension Benefit Guarantee Corp.
Is the eventual portfolio outcome going to be that much differentunder this theory than under efficient frontier theory? – Both call for diversification
– Both require a minimum return target
– Both look to increase alpha on a relative basis, or against selectedbenchmarks
Can real estate be effectively used as an immunization tool?
Regardless of theory, widely agreed today that realestate should be a part of every investor‟s portfolio
Also generally agreed that investors are on averagesignificantly underweighted in real estate – Institutional universe has approximate 2% of assets in real
estate This small allocation still represents $80 billion in privates, $12
billion in REITS and REOC‟s
– Only the largest pension funds invest in real estate 25 largest funds control 74% of all pension fund investments in
real estate – Control 82% of all pension investments in REITs
– The rest of universe hasn‟t shown up for the party!
Office and Industrial properties are most cyclical,most closely reflect economic cycles
– Office → either the best or the worst performer. A laggingindicator. Time the cycles, underweight suburban“commodity” deals in general
– Industrial → generally outperforms office, more stablereturns than office. More of a leading indicator.
Retail and Multifamily are considered more stable – Retail → negative correlation with office, good absolutereturns. Reflects consumer-driven economy – Multifamily → considered defensive, counter-cyclical.
Influenced by demographic trends as well as job growth
Property type selection within regions is important – Gets back to economic base analysis! – What industries, activities drive the local economy and will be reflected in
real estate needs? East and West
– Higher returns, higher risk – More heavily concentrated in office product because of the financial focus
of coastal economies
Midwest – Correlated with the East coast, although more heavily industrial in nature
South – Low correlations with West, higher risk adjusted returns on average than
either coast – Long term demographic shifts favor the south