Has Real Estate Come of Age?
Cheng, Ping, Lin, Zhenguo, Liu, Yingchun, Zhang, Yongmin, Journal of Real Estate Portfolio Management
This paper reveals the limitations of the classic Modern Portfolio Theory (MPT) and the fallacy of applying this theory to a mixed-asset portfolio that includes real estate. The findings suggest that the validity of the single-period MPT to multi-period investment is critically conditional on the assumption that asset returns over time are independent and identically distributed (i.i.d.) and that the real estate returns are far from this assumption. Furthermore, the analysis shows that the unique characteristics of real estate greatly complicate the mixed-asset portfolio decisions, and the long standing "real estate allocation puzzle" may be caused by the direct application of MPT to the mixed-asset portfolio.
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In the 2007 Special Issue of the Journal of Portfolio Management, the lead article by Clayton et al. (2007) declares that, after decades of evolution, real estate has finally "come of age." In the same issue, an article by Bernstein (2007) discusses what "coming of age" really means for real estate. Both articles cite the wide acceptance of private real estate as a mainstream portfolio asset class, the rapid expansion of real estate into the securitized market sector (through REITs and CMBS), the emergence of real estate-based financial derivatives, and the ever-increasing integration of real estate with the rest of the capital market as evidence that real estate is now ready for the "grownup world" of modern investment. Such an optimistic perspective is well justified, as long as we are talking about real estate as an investable asset that attracts growing interests from mainstream investors. However, if we are talking about real estate as a distinct academic discipline, particularly in the area of asset pricing and portfolio management, the reality will be less euphoric. Since "coming of age" usually means establishing one's own identity in the world and taking on responsibilities with self-reliance, real estate seems to still have a long way to go. It is perhaps true that, in the eyes of the mainstream investors, real estate is now big enough to "sit at the adult table." But exactly how big a role it should play in the investment portfolio? This type of question is the ultimate test for whether real estate investment has established its own identity.
There is a general consensus among academics and practitioners that private real estate investment can add diversification benefits to traditional security-only portfolios. But the appropriate role of real estate in a mixed-asset portfolio has remained rather controversial. On the one hand, numerous academic studies since the 1980s often conclude that real estate should constitute 15%-40% or more of a diversified portfolio (e.g., Hartzell, Hekman, and Miles, 1986; Firstenberg, Ross, and Zisler, 1988; and Hudson-Wilson, Fabozzi, and Gordon, 2005; among others). On the other hand, leading institutional investors typically have only about 3%-5% of their total assets in private real estate equity, according to recent surveys.1 Significant research effort has been undertaken for nearly three decades to reconcile the discrepancy, yet to date there appear to be no agreeable answers among academics, and perhaps even less so between academics and practitioners on the question of how much real estate a typical mixed-asset portfolio should contain.
The academic claims about optimal real estate allocation in mixed-asset portfolios are generally based on the application of Modern Portfolio Theory (MPT), pioneered by Markowitz (1952), to multiple asset classes including private real estate. Although it is well understood that private real estate does not conform to the highly liquid, informational-efficient, and frictionless public security market, upon which the MPT was premised, this knowledge is often perceived as perhaps being too basic and encompassing to be practically useful, and it has typically not prevented researchers from treating real estate indifferently from other financial assets in portfolio analysis. …