Diversification Benefits from Foreign Real Estate Investments

By Conover, C. Mitchell; Friday, H. Swint et al. | Journal of Real Estate Portfolio Management, January-April 2002 | Go to article overview

Diversification Benefits from Foreign Real Estate Investments


Conover, C. Mitchell, Friday, H. Swint, Sirmans, G. Stacy, Journal of Real Estate Portfolio Management


Executive Summary. Previous research has questioned the stability of international equity diversification. This study examines whether foreign real estate exists in a more segmented market and whether foreign real estate provides any diversification benefit beyond that obtainable from foreign stocks. Using data encompassing the stock market crash of 1987, foreign real estate was found to have a lower correlation with U.S. stocks than foreign stocks. This lower correlation is shown to be stable through time as foreign real estate has a lower correlation in nearly the entire time period. Foreign real estate was also found to have a significant weight in efficient international portfolios.

Introduction

Previous evidence suggests that real estate improves the mean variance efficiency of a diversified portfolio. Burns and Epley (1982), Miles and McCue (1982), Ennis and Burik (1991) and Gilberto (1993), all using Real Estate Investment Trust (REIT) data, find that including real estate investments in the United States improves the risk and return tradeoff for U.S. investors. Diversifying with international real estate is shown to be beneficial by a number of studies using a variety of data. These studies include: Sweeney (1989) using international rent indices, Giliberto (1990) using property share returns, Liu and Mei (1993) using foreign property trust and property-related securities, and Eichholtz (1996) using Limburg Institute of Financial Economics (LIFE) data for eight foreign countries and the U.S.

International diversification with stocks and bonds has long been advocated due to the low correlation between international equity markets (Solnik, 1974). However, recent evidence suggests that international diversification with stocks and bonds is least effective when investors need it the most. Bertero and Mayer (1990), King and Wadhwani (1990) and King, Sentana and Wadhwani (1994) find greater integration of world stock markets in the period surrounding the crash of 1987. Longin and Solnik (1995) use data from 1960-1990 and find increased correlation of international stock markets when stock market volatility increases. Sinquefield (1996) questions the wisdom of international stock diversification in general. Using the Europe Australia Far East (EAFE) stock portfolio, he does not find any benefits from international stock diversification, unless an investor concentrates on value and/or small firm stocks overseas.

A possible explanation for the failure of international stock diversification in improving mean variance portfolio efficiency is that stock markets are becoming more integrated internationally due to the opening of formerly closed economies, the cross listing of securities and improvements in security liquidity from technological advances. In an integrated international capital market, the action of arbitrageurs will ensure that assets of similar risk will offer the same return. However, arbitrageurs may be unable to ascertain the risk and required return of real estate internationally, due to differing appraisal methods throughout the world. Arbitrage may also be difficult due to the physically immovable and local nature of real estate. Hence, international real estate markets may be more segmented and offer greater mean variance efficiency in a portfolio for the investor, especially in times of greater stock market volatility.

The purpose of this article is to determine if international real estate investment offers diversification benefits superior to that available from international stocks in periods of high volatility. Previous research shows that real estate can add to portfolio diversification. Asabere, Kleiman and McGowan (1991) conclude that international real estate should improve portfolio efficiency for U.S. investors. Liu and Mei (1998) find that investing in international real estate securities provides additional diversification benefits beyond that associated with international stocks. …

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