Real estate portfolio size and risk reduction

The reduction of portfolio risk is important to all investors but is particularly important to real estate investors as most property portfolios are generally small. As a consequence, portfolios are vulnerable to a significant risk of under-performing the market, or a target rate of return and so investors may be exposing themselves to greater risk than necessary. Given the potentially higher risk of underperformance from owning only a few properties, we follow the approach of Vassal (2001) and examine the benefits of holding more properties in a real estate portfolio. Using Monte Carlo simulation and the returns from 1,728 properties in the IPD database, held over the 10-year period from 1995 to 2004, the results show that increases in portfolio size offers the possibility of a more stable and less volatile return pattern over time, i.e. down-side risk is diminished with increasing portfolio size. Nonetheless, increasing portfolio size has the disadvantage of restricting the probability of out-performing the benchmark index by a significant amount. In other words, although increasing portfolio size reduces the down-side risk in a portfolio, it also decreases its up-side potential. Be that as it may, the results provide further evidence that portfolios with large numbers of properties are always preferable to portfolios of a smaller size.

The production and consumption of commercial real estate market forecasts

Whilst the vast majority of the research on property market forecasting has concentrated on statistical methods of forecasting future rents, this report investigates the process of property market forecast production with particular reference to the level and effect of judgemental intervention in this process. Expectations of future investment performance at the levels of individual asset, sector, region, country and asset class are crucial to stock selection and tactical and strategic asset allocation decisions. Given their centrality to investment performance, we focus on the process by which forecasts of rents and yields are generated and expectations formed. A review of the wider literature on forecasting suggests that there are strong grounds to expect that forecast outcomes are not the result of purely mechanical calculations.

Hedging private international real estate

The performance of an international real estate investment can be critically affected by currency fluctuations. While survey work suggests large international investors with multi-asset portfolios tend to hedge their overall currency exposure at portfolio level, smaller and specialist investors are more likely to hedge individual investments and face considerable specific risk. This presents particular problems in direct real estate investment due to the lengthy holding period. Prior research investigating the issue relies on ex post portfolio measure, understating the risk faced. This paper examines individual risk using a forward-looking simulation approach to model uncertain cashflow. The results suggest that a US investor can greatly reduce the downside currency risk inherent in UK real estate by using a swap structure – but at the expense of dampening upside potential.

Diversification when it hurts? The joint distributions of real estate and equity markets

Much of the literature on the construction of mixed asset portfolios and the case for property as a risk diversifier rests on correlations measured over the whole of a given time series. Recent developments in finance, however, focuses on dependence in the tails of the distribution. Does property offer diversification from equity markets when it is most needed - when equity returns are poor. The paper uses an empirical copula approach to test tail dependence between property and equity for the UK and for a global portfolio. Results show strong tail dependence: in the UK, the dependence in the lower tail is stronger than in the upper tail, casting doubt on the defensive properties of real estate stocks.

Real estate capital flows and transitional economies

reign real estate capital was a major source of financing domestic property market office construction in Central Europe after the fall of the Berlin Wall in 1989. During the 1990s, over 800 office buildings were either newly constructed or refurbished in Budapest, Prague and Warsaw. The primary focus of this analysis is explaining the spatial construction and redevelopment patterns of the post-1989 office buildings in these cities. Secondarily, we analyze the correlation of foreign direct investment flows to annual construction of office buildings. We seek to explain the location of new or refurbished office buildings in the central business district (CBD) or in non-CBD locations in terms of the effect of time, size of property and other variables, and test whether there is a positive correlation relationship of foreign direct investment flows and new office construction or refurbishment. Integrating relevant foreign direct investment (FDI), economic geography and property theories in the research, the authors attempt to bridge existing gaps in the literature.

The marginal benefit of diversification in commercial real estate portfolios

The number of properties to hold to achieve a well-diversified real estate property portfolio presents a puzzle, as the estimated number is considerably higher than that seen in actual portfolios. However, Statman (1987) argues that investors should only increase the number of holdings as long as the marginal benefits of diversification exceed their costs. Using this idea we find that the marginal benefits of diversification in real estate portfolios are so small that investors are probably rational in holding small portfolios, at least as far as the reduction in standard deviation is concerned.

How often does direct real estate increase the risk-adjusted performance of the US mixed-asset portfolio?

The “case for real estate” in the mixed-asset portfolio is a topic of continuing interest to practitioners and academics. The argument is typically made by comparing efficient frontiers of portfolio with real estate to those that exclude real estate. However, most investors will have held inefficient portfolios. Thus, when analysing the real estate’s place in the mixed-asset portfolio it seems illogical to do so by comparing the difference in risk-adjusted performance between efficient portfolios, which few if any investor would have held. The approach adopted here, therefore, is to compare the risk-adjusted performance of a number of mixed-asset portfolios without real estate (which may or not be efficient) with a very large number of mixed-asset portfolios that include real estate (which again may or may not be efficient), to see the proportion of the time when there is an increase in risk-adjusted performance, significant or otherwise using appraisal-based and de-smoothed annual data from 1952-2003. So to the question how often does the addition of private real estate lead to increases the risk-adjusted performance compared with mixed-asset portfolios without real estate the answer is almost all the time. However, significant increases are harder to find. Additionally, a significant increase in risk-adjusted performance can come from either reductions in portfolio risk or increases in return depending on the investors’ initial portfolio structure. In other words, simply adding real estate to a mixed-asset portfolio is not enough to ensure significant increases in performance as the results are dependent on the percentage added and the proper reallocation of the initial portfolio mix in the expanded portfolio.

Gauging the investment potential of international real estate markets

Investing in real estate markets overseas means venturing into the unknown, where you meet unfamiliar political and economic environments, unstable currencies, strange cultures and languages, and so although the advantages of international diversification might appear attractive, the risks of international investment must not be overlooked. However, capital markets are becoming global markets, and commercial real estate markets are no exception, accordingly despite the difficulties posed by venturing overseas no investor can overlook the potential international investment holds out. Thus, what strategies are appropriate for capitalising on this potential? Three issues must be considered: (1) the potential of the countries real estate market in general; (2) the potential of the individual market sectors; and (3) the investment process itself. Although each step in foreign real estate investment is critical, the initial assessment of opportunities is especially important. Various methods can be used to achieve this but a formal and systematic analysis of aggregate market potential should prove particularly fruitful. The work reported here, therefore, develops and illustrates such a methodology for the over 50 international real estate markets.

The consistency of private and public real estate within mixed-asset portfolios

This study considers the consistency of the role of both the private and public real estate markets within a mixed-asset context. While a vast literature has developed that has examined the potential role of both the private and public real estate markets, most studies have largely relied on both single time horizons and single sample periods. This paper builds upon the analysis of Lee and Stevenson (2005) who examined the consistency of REITs in a US capital market portfolio. The current paper extends that by also analyzing the role of the private market. To address the question, the allocation of both the private and traded markets is evaluated over different holding periods varying from 5- to 20-years. In general the results show that optimum mixed-asset portfolios already containing private real estate have little place for public real estate securities, especially in low risk portfolios and for longer investment horizons. Additionally, mixed-asset portfolios with public real estate either see the allocations to REITs diminished or eliminated if private real estate is also considered. The results demonstrate that there is a still a strong case for private real estate in the mixed-asset portfolio on the basis of an increase in risk-adjusted performance, even if the investor is already holding REITs, but that the reverse is not always the case.

Analysing UK real estate market forecast disagreement

Given the significance of forecasting in real estate investment decisions, this paper investigates forecast uncertainty and disagreement in real estate market forecasts. Using the Investment Property Forum (IPF) quarterly survey amongst UK independent real estate forecasters, these real estate forecasts are compared with actual real estate performance to assess a number of real estate forecasting issues in the UK over 1999-2004, including real estate forecast error, bias and consensus. The results suggest that real estate forecasts are biased, less volatile compared to market returns and inefficient in that forecast errors tend to persist. The strongest finding is that real estate forecasters display the characteristics associated with a consensus indicating herding.

An evaluation of the performance of UK real estate forecasters

Given the significance of forecasting in real estate investment decisions, this paper investigates forecast uncertainty and disagreement in real estate market forecasts. It compares the performance of real estate forecasters with non-real estate forecasters. Using the Investment Property Forum (IPF) quarterly survey amongst UK independent real estate forecasters and a similar survey of macro-economic and capital market forecasters, these forecasts are compared with actual performance to assess a number of forecasting issues in the UK over 1999-2004, including forecast error, bias and consensus. The results suggest that both groups are biased, less volatile compared to market returns and inefficient in that forecast errors tend to persist. The strongest finding is that forecasters display the characteristics associated with a consensus indicating herding.

Non-normal real estate return distributions by property type in the U.K.

Investment risk models with infinite variance provide a better description of distributions of individual property returns in the IPD database over the period 1981 to 2003 than Normally distributed risk models, which mirrors results in the U.S. and Australia using identical methodology. Real estate investment risk is heteroscedastic, but the Characteristic Exponent of the investment risk function is constant across time yet may vary by property type. Asset diversification is far less effective at reducing the impact of non-systematic investment risk on real estate portfolios than in the case of assets with Normally distributed investment risk. Multi-risk factor portfolio allocation models based on measures of investment codependence from finite-variance statistics are ineffectual in the real estate context.

The impact of real estate on the terminal wealth of the UK mixed-asset portfolio

The argument for the inclusion of real estate in the mixed-asset portfolio has concentrated on examining its effect in reducing the portfolio risk - the time series standard deviation (TSSD), mainly using ex-post time series data. However, the past as such is not really relevant to the long-term institutional investors, such as the insurance companies and pension funds, who are more concerned the terminal wealth (TW) of their investments and the variability of this wealth, the terminal wealth standard deviation (TWSD), since it is from the TW of their investment portfolio that policyholders and pensioners will derive their benefits. These kinds of investors with particular holding period requirements will be less concerned about the within period volatility of their portfolios and more by the possibility that their portfolio returns will fail to finance their liabilities. This variability in TW will be closely linked to the risk of shortfall in the quantity of assets needed to match the institution’s liabilities. The question remains therefore can real estate enhance the TW of the mixed-asset portfolio and/or reduce the variability of the TW. This paper uses annual data from the United Kingdom (UK) for the period 1972-2001 to test whether real estate is an asset class that not only reduces ex-post portfolio risk but also enhances portfolio TW and/or reduces the variability of TW.

The impact of real estate on the mixed-asset portfolio in periods of financial stress

The case for holding real estate in the mixed-asset portfolio is typically made on its stabilising effect as a result of its diversification benefits. However, portfolio diversification often fails when it is most needed, i.e. during periods of financial stress. In these periods, the variability of returns for most asset classes increases thus reducing the stabilising effect of a diversified portfolio. This paper applies the approach of Chow et al (1999) to the US domestic mixed-asset portfolio to establish whether real estate, represented by REITs, is especially useful in times of financial stress. To this end monthly returns data on five assets classes: large cap stocks, small cap stocks, long dated government bonds, cash (T-Bills) and real estate (REITs) are evaluated over the period January 1972 to December 2001. The results indicate that the inclusion of REITs in the mixed-asset portfolio can lead to increases or decreases in returns depending on the asset class replaced and whether the period is one of calm or stress. However, the inclusion of REITs invariably leads to reductions in portfolio risk that are greater than any loss in return, especially in periods of financial stress. In other words, REITs acts as a stabilising force on the mixed-asset portfolio when it is most needed, i.e. in periods of financial stress.

The persistence of real estate fund performance

This paper examines the short and long-term persistence of tax-exempt real estate funds in the UK through the use of winner-loser contingency table methodology. The persistence tests are applied to a database of varying numbers of funds from a low of 16 to a high of 27 using quarterly returns over the 12 years from 1990 Q1 to 2001 Q4. The overall conclusion is that the real estate funds in the UK show little evidence of persistence in the short-term (quarterly and semi-annual data) or for data over a considerable length of time (bi-annual to six yearly intervals). In contrast, the results are better for annual data with evidence of significant performance persistence. Thus at this stage, it seems that an annual evaluation period, provides the best discrimination of the winner and loser phenomenon in the real estate market. This result is different from equity and bond studies, where it seems that the repeat winner phenomenon is stronger over shorter periods of evaluation. These results require careful interpretation, however, as the results show that when only small samples are used significant adjustments must be made to correct for small sample bias and second the conclusions are sensitive to the length of the evaluation period and specific test used. Nonetheless, it seems that persistence in performance of real estate funds in the UK does exist, at least for the annual data, and it appears to be a guide to beating the pack in the long run. Furthermore, although the evidence of persistence in performance for the overall sample of funds is limited, we have found evidence that two funds were consistent winners over this period, whereas no one fund could be said to be a consistent loser.