Academic journal article Journal of Real Estate Portfolio Management

Leverage and Real Estate Investment in Mixed-Asset Portfolios

Academic journal article Journal of Real Estate Portfolio Management

Leverage and Real Estate Investment in Mixed-Asset Portfolios

Article excerpt

Executive Summary. Academics examining real estate's potential to improve the efficiency of mixed-asset portfolios usually view the situation from the perspective of the debtfree equity investor This study investigates the implications for portfolio performance of holding leveraged real estate. Of particular interest is the effect of including leveraged real estate in portfolios held by nontaxable institutions. To investigate these effects, a bootstrap estimate with a Markowitz mean-variance analysis is used to generate efficient portfolio frontiers from annual investment performance data covering both securities and real estate. The efficient frontiers represent different assumed opportunity sets which vary depending on the inclusion of debt-free real estate, leveraged real estate and real estate tax effects. All the appraisal-based real estate data used in this study were adjusted for "smoothing".

Overall, the results are consistent with theoretical expectations. Beginning with a securities-only opportunity set (stocks, corporate bonds and t-bills), adding debt-free real estate produced higher portfolio efficiency (lower risk) for all investors except those with the very lowest risk preference. For nontaxable investors, leveraging the real estate caused a decline in mixed-asset portfolio efficiency. However, for taxable investors, leveraging the real estate improved portfolio performance.

INTRODUCTION

Real estate has long been considered a major asset class category, but only during the past two decades has it been carefully analyzed from the perspective of modern portfolio theory (MPT). MPT holds that the value of an asset to investors depends on both its return and the expected risk that cannot be eliminated through diversification (systematic risk). Diversification is effective when the investment returns of different assets held in a portfolio are not highly correlated. If an asset held as part of a diversified portfolio has little positive correlation with the other assets in the same portfolio, it can contribute by reducing the variance of the portfolio's investment returns.

Several studies have investigated the importance of real estate relative to other investment vehicles such as stocks and bonds (including Friedman, 1970; Roulac, 1976; Brueggeman, Chen and Thibodeau, 1984; Sirmans and Sirmans, 1987). Other studies have focused on the effectiveness of real estate investment in contributing to the efficiency of mixed-asset portfolios by providing diversification and expected returns sufficient to compensate for non-diversifiable risk (Webb and Rubens, 1988).1 In general, the findings of the studies cited above support the view that real estate can be a valuable component of a mixedasset portfolio that also includes such traditional asset categories as stocks, government bonds and t-bills. On average, historical real estate investment returns have been reported to be higher than those of every other asset class except common stock. The correlation between real estate returns and stock and bond returns is low.2 Thus, the inclusion of real estate in diversified portfolios may well allow investors to achieve mean-variance efficient combinations superior to any available from investment in financial securities alone.

Most of the research concerned with real estate's potential portfolio contributions has examined real estate from the viewpoint of an unleveraged equity investor, in spite of the fact that real estate projects are often financed with large amounts of debt. Beginning with the work of Modigliani and Miller (MM) (1958, 1963), most academics have come to accept the theory that leverage does not enhance value unless it provides an income tax shield. In a real estate context, this implies that any improvement in expected investment return to the equity position resulting from the use of leverage will be offset by increased risk. Leverage is only beneficial when the investor is able to reduce the cost of debt by deducting the interest component of mortgage debt service from taxable income. …

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