# New Trends in Portfolio Theory

By Hudson-Wilson, Susan | Journal of Property Management, May-June 1990 | Go to article overview

# New Trends in Portfolio Theory

Hudson-Wilson, Susan, Journal of Property Management

As institutional interest in real estate portfolios has grown, increasingly more sophisticated techniques for managing the return and risk of portfolio real estate have evolved. This article explores some current and future forms of analysis used in balancing a portfolio.

The key to modern portfolio theory is a mathematical model. Our analysis looks at the bottom line from an investor's point of view-the rate of return. We analyze both the supply available in the market and the demand for product. The interaction of these two factors is the most important determinant of rate of return. Analyzing just the economic base of a market is doing only half of the job. It is the interaction of supply and demand that creates a rate of return.

There are two additional factors that affect rate of return:

* Inflation-not a general domestic rate of inflation, but inflation in different product types, in different markets, at different times.

* Capital market conditions-both systematic and nonsystematic.

* These factors are less important on average than market condition, but can be very important at the margin.

By reviewing these factors, we calculate an absolute rate of return for a property. This analysis is done at the city level and then for each property-type within a city. The result is a rate of return for each of the four major property types in each of the 65 cities we monitor

The next step in the analysis is to assess the standard deviation of the rate of return-the measurement of the riskiness of the investment. The standard deviation measures the size of the range of rates of return that an asset or a portfolio might experience. Risky assets have very high standard deviations because there is a wide range of possible rates of return they may generate. A less risky asset has a narrower spread of possible returns.

Having established these two factors, we move on to calculate risk-adjusted rates of return-a "bang-for-the-buck" concept. We attempt to balance two factors; the higher the rate of return, the higher the acceptable risk, at least to a point.

Phase 2-A portfolio-wide return

Most traditional real estate analyses would stop there. Modern portfolio theory attempts to take the analysis one step further by thinking in terms of portfolios of investments, not just the risk/ return on each individual investment.

When one asset is combined with another to form a portfolio, it is not a neutral event. The return and the riskiness of the portfolio are altered, The return of the portfolio will simply be the weighted sum of the two returns. The riskiness of the portfolio will be affected by the correlation between those two returns.

If the two returns behave in exactly the same way (a correlation of one), then the combination of one with the other will generate a portfolio standard deviation that is simply the weighted sum of the two standard deviations. In effect, you have bought the same asset twice, even if they are different property types in different cities. You have achieved no lessening of risk in the overall portfolio.

If you buy two assets that behave differently and therefore have a correlation coefficient of less than one, you will have reduced the risk of the portfolio. The portfolio's standard deviation will be less than the weighted sum of the two risks.

This is the key to portfolio management. If you can reduce the risk in the portfolio, you, in effect, can raise the risk-adjusted return of that portfolio. You enhance the bang for the buck.

The difficulty, of course, is finding measures of the similarities and differences among cities and property types. …

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