Diversification Effects of Direct versus Indirect Real Estate Investments in the U.K

Article excerpt

Executive Summary.

This study uses annual data from 1975 through 2003 to construct mean-variance optimal portfolios for the United Kingdom. Real estate return data for all U.K properties from the Investment Property Databank (IPD), for U.K. pooled property funds, and for U.K. property shares are used, in addition to U.K. common stocks (equities) and gilts (government bonds). The different mixed-asset portfolio allocations using the different real estate return series are compared/contrasted. Finally, the return series are unbundled for U.K. IPD real estate, U.K. common stocks, and U.K. gilts into income and appreciation returns and additional optimal mean-variance portfolios, which are constructed for income returns, appreciation returns, and total returns (income and appreciation returns).

In a mixed-asset portfolio, direct investment into real estate is often used to provide diversification benefits, notably in large institutional portfolios (Hoesli, MacGregor, Adair, and McGreal, 2002). Investments in real estate cannot be considered in isolation, but must be placed in the context of other investment opportunities within a mixed-asset portfolio, notably equities and bonds. The key criteria in the investment decision-making process for determining allocations across the asset classes, as shown from many studies at a national and international level, are expected return and risk (MacGregor and Nanthakumaran, 1992; and Newell and Webb, 1996).

This study constructs mean-variance optimal portfolios for the United Kingdom focusing on the allocation by asset class across low-, medium-, and high-risk portfolios. The portfolios are based on the three main asset classes: common stock, gilts/bonds, and real estate. Where this analysis differs from previous work is in a comparative analysis of direct property returns [total return using the Investment Property Databank (IPD)] with indirect or securitized real estate (pooled property fund returns and real estate equities). Secondly, the analysis considers unbundled returns using the income and appreciation returns separately for equities, bonds, and IPD real estate (direct real estate investment).

The next section of the paper contains the literature review of the role of real estate within portfolios and diversification strategies. There is then a brief review of the research design and the nature of the data. The paper then moves to a discussion of optimal portfolios including low-, medium- and high-risk scenarios for each portfolio. The paper closes with a summary and concluding

remarks.

Literature Review

The theoretical framework for analyzing return and risk is well established in the literature, normally focusing on the role of real estate in mixed-asset portfolios and selected via modern portfolio theory (Hoesli and MacGregor, 2000). More specifically, the return and risk for each asset class and the correlation coefficients between the returns on each pair of assets are analyzed. The purpose of diversifying an investment portfolio is to reduce non-systematic risk. The benefits of diversification arise from the less than perfect correlation between the various market segments. As Lee (2003) emphasizes, the lower the level of correlation between assets, the greater the potential for portfolio risk reduction. The success of a particular diversification strategy consequently depends on the quality of the estimated correlation between assets. Hamelink, Hoesli, Lizieri, and MacGregor (2000) argue that the classification of property markets defines the dimensions of market risk. This implies that the drivers of property-market performance are influenced differentially by office, retail, and industrial markets. The same applies for economic diversification and for combined property type and area classifications. If however, the type or area groupings used do not define the dimensions of market risk, then optimal diversification will not be achieved. …