International Asset Allocation with Real Estate Securities in a Shortfall Risk Framework: The Viewpoint of German and U.S. Investors

By Maurer, Raimond; Reiner, Frank | Journal of Real Estate Portfolio Management, January-April 2002 | Go to article overview

International Asset Allocation with Real Estate Securities in a Shortfall Risk Framework: The Viewpoint of German and U.S. Investors


Maurer, Raimond, Reiner, Frank, Journal of Real Estate Portfolio Management


Executive Summary. This study analyses the diversification potential of integrating indirect real estate investments in international investment portfolios. To this end, monthly index-return time-series for the time-period from January, 1985, through June, 2001, from real estate investment companies, common stocks and bonds in France, Germany, Great Britain, Switzerland and the United States were used. Due to the critical normal distribution assumption, a mean / lower-partial-moment framework was employed. In order to take into account the influence of the currency risk for international investments, the analyses have been undertaken with and without hedging the currency risk. The viewpoint of a German as well as that of a U.S. investor was taken to gain insight into the dependency of the diversification potential on the reference currency of the investor.

Introduction

Traditionally, real estate has been regarded as an asset class with a specific risk/return characteristic and low co-movements with domestic bond and stock markets. Therefore, adding real estate to a portfolio of stocks and bonds should improve the risk/return profile from the perspective of a domestic investor. Using the concept of hedged indices, Stevenson (2000) recently showed that these low co-movements could not only be found between the local but also between international stock/ bond and real estate markets. Because the benefits of international portfolio diversification are mainly due to low co-movements between different national asset-markets, adding real estate into an international portfolio of stocks and bonds should improve the benefits from international portfolio diversification substantially. However, the possibility to create a well-diversified international property portfolio is in contrast to the traditional asset categories burdened with some problematic features. The large lot size of property investments, the lack of a central market, the existence of high transaction costs, low liquidity, the need of local market knowledge and management requirements imply that there are substantial problems for private and institutional investors who want to add direct property investments into their (international) portfolios.

One way to avoid the drawbacks of direct property investments might be to purchase units of real estate companies as an indirect (securitized) form of real estate investment. Real estate investment companies can be characterized as pools of assets in which investors participate in the financial results of a specific portfolio of professionally managed income producing properties, such as housing, commercial properties or both. The shares of property investment companies are liquid in the sense that there exists an active secondary market. A critical question, which has been the centerpiece of several empirical studies (eg., Eichholtz, 1996a, b; Eichholtz, Huisman, Koedijk and Schuin, 1997; and Liu and Mei, 1998), is whether diversifying internationally with real estate securities provides incremental diversification benefits. The main objective of this study is to provide additional empirical evidence concerning the diversification benefits of real estate securities. Therefore, this study extends the existing studies with respect to the database used and concerning the following aspects.

Fluctuating exchange rates represent an additional risk factor for investors who want to diversify internationally. Therefore, it is important to study whether hedging the exchange rate risk influences the diversification potential. Studies regarding international bond and stock markets by, for example, Eun and Resnick (1988, 1994), Eaker and Grant (1990), Eaker, Grant and Woodard (1991), Kaplanis and Schaefer (1991) and Glen and Jorion (1993) have registered significant performance differences for hedged and unhedged portfolios. For this reason, the dependency of the diversification potential on a currency hedging strategy using forward contracts with optimal hedge ratios is examined. …

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