Real Estate in a Mixed Asset Portfolio

Optimization at an Example


Term Paper, 2012

10 Pages, Grade: 8.0


Excerpt

Table of Contents

1. Introduction

2. Literature review

3. Descriptive Statistics

4. Correlation and bear market

5. Mean-Variance Analysis

6. Real life analysis

7. Conclusion

8. References

1. Introduction

Most of today’s portfolios include bonds and equities. This composition enables investors to reduce firm-specific risk and diversify among different asset classes. Important assets that could further enhance diversification are investments in real estate. The risk-reducing effect of real estate partly stems from its local nature. Furthermore, investors, both local and international, face differences concerning the information available with respect to the real estate market and the bond or stock market. The former offers less information to investors than the latter market. Real estate markets are less integrated, which means that there are not many investments made in this market. This can be a further explanation of the positive diversification effects of real estate. Therefore, one could ask whether direct- or indirect real estate investment enhances diversification. The purpose of this report is to investigate whether there is a positive diversification effect of real estate on the risk of a portfolio.

The report takes a look at previous findings of researchers concerning the diversification effect of real estate and proceeds with the analysis of the descriptive statistics. Next, the correlation between indirect and direct real estate, bonds and equity is examined followed by the mean-variance analysis and the creation of the efficient frontier by real data. Afterwards, the report focuses on the real life analysis as well as the advantages and disadvantages of real estate investments. Finally, it is argued whether the inclusion of real estate in a portfolio leads to better diversification.

2. Literature review

Chapter 21 of Geltner and Miller (2010) depicts the role of a real estate investment as a diversifier in modern portfolio theory. Investors are generally concerned about the portfolio’s risk exposure in relation to total return. When applying portfolio theory to a portfolio consisting of various asset classes such as equity, bonds or real estate estimates concerning the stock market volatility, long-term bond volatility and the real estate market volatility should be made. Furthermore, the correlations between these asset classes have to be analyzed. Portfolio theory or mean-variance portfolio theory (MPT) has the ultimate aim to minimize the portfolios volatility yet maximize an investors long-run rate of return. MPT is capable of delivering these asset class allocations with regard to the constraints. This can also be illustrated graphically, using the concept of the efficient frontier. Here, each asset and each combination of assets can be plotted in a framework of risk and return. A single point in the framework represents each asset class but when allowing for diversification of different assets the risk and return possibilities expand to curved lines representing combinations of different assets. Investors prefer the dominant portfolios, as they are efficient portfolios building the efficient frontier guaranteeing for the highest return at a certain risk level. An indifference curve, tangent to the most northwest point on the efficient frontier is the best possible and efficient portfolio with regard to an investor’s risk tolerance.

The article „Does International Diversification Work Better for Real Estate than for Stocks and Bonds?“ by Eichholtz (1996) deals with the international diversification effect on the risk of investment portfolios. Generally, as international asset returns are less correlated than in domestic markets, diversification reduces risk. Eichholtz (1996) explains that national real estate securities are more risky than common stocks but that correlations between international property share indexes are lower than those of bond and stock indexes meaning that international diversification is most effective for real estate securities. Furthermore, it is shown that international property share correlations are increasing between countries within the same continent, but are decreasing between countries on different continents. This means that international real estate diversification can be effective despite the fact that the standard deviations of national property share indexes are, on average somewhat higher than for common stocks and bonds.

Thus, investing in property companies, operating in their domestic market yields superior returns in comparison to international diversified property companies. This stems from the local specialized market knowledge of the national companies. Nevertheless, one can conclude that international diversification works better for property shares than it does for direct real estate.

3. Descriptive Statistics

The following mean returns and the corresponding volatility for equities, bonds, indirect real estate investments (IREI) and direct real estate investments (DREI) are based on monthly return data from February 1988 until December 1999 from the UK for a total of 155 observations. In our sample equities return on average 1.16% with a volatility of 5% compared to bonds that only returned 0.87% but with a much lower standard deviation of 1.04%. Interestingly, IREI had a mean return of 0.69% with a standard deviation of 6.24%. They return less than bonds while having a higher standard deviation than equities. Consistent with this, IREI returns have the highest range before equities, which are followed by bonds and DREI. This occurrence is investigated in a later part of this paper. DREI had a higher mean return of about 0.85% but with a considerably lower standard deviation of 0.88%. The following table gives a brief overview over the summary statistics for each category.

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Details

Title
Real Estate in a Mixed Asset Portfolio
Subtitle
Optimization at an Example
College
Maastricht University  (SBE)
Course
Investment analysis and portfolio management
Grade
8.0
Authors
Year
2012
Pages
10
Catalog Number
V215069
ISBN (eBook)
9783656431619
ISBN (Book)
9783656438427
File size
656 KB
Language
English
Tags
real estate in a mixed asset portfolio, diversification, real estate, bond, mixed asset, standard deviation, volatility, real asset
Quote paper
Maximilian Wegener (Author)Janis Klenk (Author)Christine Nicoll (Author)Julia Savvopoulos (Author), 2012, Real Estate in a Mixed Asset Portfolio, Munich, GRIN Verlag, https://www.grin.com/document/215069

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