Is there a diversification paradox in real estate investment funds' value?
| Date | 09 August 2024 |
| Pages | 554-575 |
| DOI | https://doi.org/10.1108/JPIF-02-2024-0025 |
| Published date | 09 August 2024 |
| Subject Matter | Property management & built environment,Real estate & property,Property valuation & finance |
| Author | Pedro A. Fernandes,João Carvalho das Neves,Jorge Caiado |
Is there a diversification paradox in
real estate investment
funds’value?
Pedro A. Fernandes
ISEG - Lisbon School of Economics and Management, Universidade de Lisboa,
Lisbon, Portugal
Jo~
ao Carvalho das Neves
ADVANCE, ISEG - Lisbon School of Economics and Management,
Universidade de Lisboa, Lisbon, Portugal, and
Jorge Caiado
CEMAPRE/REM –Research in Economics and Mathematics,
ISEG - Lisbon School of Economics and Management, Universidade de Lisboa,
Lisbon, Portugal
Abstract
Purpose –This paper studies diversification and value in the investmentportfolios of (non-listed) Real Estate
Investment Funds (REIFs) exploring how the value of diversification is captured by the market and by
investors (beyond reported valuations).
Design/methodology/approach –We apply the Herfindahl-Hirschman Index (HHI) to study the level of
concentration versus diversification in the investment portfolios of REIFs (both in terms of segment and
geographical diversification). We use a dataset from INREV with data from 62 investment portfolios, with an
average of 86 REIFs per portfolio for the period of 2008–2020 (to study segment diversification). We use a
second dataset from INREV with data from 30 investment portfolios with an average of 79 REIFs per portfolio
for the period of 2005–2020 (to study geographical diversification). We employ a cluster analysis approach to
identify common features among the investment funds.
Findings –We conclude that (segment diversified) portfolios with higher degrees of leverage exhibit higher income
yields, albeit diversificationis captured indirectly through asset choices –more diversified portfolios tend to exhibit a
stronger risk and return relationship. Also, geographical diversification creates value (more significantly by for the
correct combination of countries carefully choosing what different geographies to group in the diversified portfolio).
Research limitations/implications –One limitation of our study is that our portfolios are funds of funds, since
the available data could not reach the asset detail, but we believe this does not compromise our results.
Practical implications –Diversification leads to higher risk-adjusted returns which suggests that properties
may be undervalued (market value) in the framework of the Gordon Model, contrary to expectations (regarding
investment value).
Originality/value –Investors capture the value of diversification differently, suggesting a gap between
market value and investment value that can be explored.
Keywords Real estate diversification, Herfindahl-Hirschman index, Investment portfolios, Cluster analysis,
Non-hierarchical clustering
Paper type Research paper
1. Introduction
Diversification among assets in an investment portfolio (Markowitz, 1952;Treynor, 1961,1962;
Sharpe, 1964;Lintner, 1965;Viezer, 2000) should be considered to estimate the appropriate cost of
capital (Easton, 2004) used to determine the value of the portfolio (Gordon and Shapiro, 1956).
JPIF
42,6
554
JEL Classification —G11, G12, L25, R30, R39
The authors thank the financial support from Project CEMAPRE/REM - UIDB/05069/2020 financed
by FCT/MCTES through national funds.
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1463-578X.htm
Received 27 February 2024
Revised 23 June 2024
Accepted 23 June 2024
Journal of Property Investment &
Finance
Vol. 42 No. 6, 2024
pp. 554-575
© Emerald Publishing Limited
1463-578X
DOI 10.1108/JPIF-02-2024-0025
The risk-adjusted discount rate accounts for both risk and the time value of money
(Gordon and Shapiro, 1956;Modigliani and Miller, 1958;Ang et al., 2018), impacting asset
valuation. Leverage, taxation, liquidity and management quality affect the judgment on the
discount rate to use (Geltner and Mei, 1995;Barkham and Ward, 1999). In a portfolio where
assets are not perfectly correlated, diversification reduces the risk of the portfolio, so, it would
be expected that the required rate of return at the portfolio level would be lower than the
average of the individual assets in the portfolio.
Real Estate Investment Funds (REIFs)invest in different segments of realestate properties
and in different geographies (Eichholtz et al., 2011;Feng et al., 2019;MacGregor, Schulz and
Zhao, 2019), offering diversification at these two levels. Therefore, it is crucialto evaluate the
bestway to diversify within a real estateportfolio (Viezer, 2000;MacGregor et al., 2019)and how
the market andinvestors capture its value.Most REIFs are not publicly traded(INREV, 2022),
contrarilyto Real Estate InvestmentTrusts (REITs), not havinga daily valuation (Farrellyand
Stevenson,2019) and suffering from the “escrow lag”:price changes may only be incorporated
several months afterthe effective transactions have occurred (Hoesli and Malle, 2022).
Furthermore, REIF’s value is calculated mostly as the sum of these individual properties’
valuations (INREV, 2022), which does not consider the effect of asset correlation, that is, the
risk diversification effect within the fund. One explanation for this approach lies in the fact
that if properties were to be sold in the market, it would not be expected to get a price different
from the market value (following the EVS 2020 definition of market value, which is also
aligned with the IVS, 2022 standards (The European Group of Valuer’s Association
TEGOVA, 2021;International Valuation Standards Council, 2022). Accordingly, if specific
risk can be diversified and investors should not be rewarded for this risk (Markowitz, 1952),
how is the value of diversification captured in fund value (and in reported valuations)?
The most basicform to measure portfolio’sdiversification is determiningthe weight of each
asset in the total. In this paper we measure diversification using the Herfindahl-Hirschman
Index (HHI), an index which was originally developed to study concentration in a particular
industry(Hall and Tideman, 1967). Appliedto the financial markets, the HHI allowsto measure
funds’diversification which is commonly usedto evaluate an Exchange-Traded Fund (ETF)
diversification and sometimes the funds’issuers provide HHIs in fact sheets or products
characteristics. This is the reason it makes sense also to use theHHI in this study.
The purpose of this paper is to study the relationship between diversification and value
within the investment portfoliosof (non-listed) REIFs. Our objectiveis to extend the use of the
HHI to study the level of concentration vs diversification within the investment portfolios of
REIFs (both in terms of segment diversification and geographical diversification). Therefore,
our researchquestion is as follows:Is there a diversificationparadox in the valuation ofREIFs?
To the best of our knowledge, this is the firststudy to be carried out on diversification and
valuecreation in the unlisted (European)real estate industry,where, in practice,the valuation of
REIFs is the sum of individual assets values, with an “escrow lag”and without considering
their diversification in a context with infrequent market transactions. The literature clearly
points out the benefits of risk dispersion, although, in practice,its reported valuations do not
reflect it. To bypass this issue, as explained above, we propose relating the calculated and
reportedvalue of REIFs’investmentportfolioswith the value they shouldhave if diversification
was properlyaccounted for when estimatingthe fund’s value. Accordingly,our paper provides
insights on how the market and investors should approach these issues, while capturing the
value of diversification in REIFs and by relating market value with investment value.
We perform this study with data from the European Association for Investors in Non-
Listed Real Estate Vehicles (INREV). This is a platform that shares data and knowledge
regarding the unlisted real estate industry (INREV, 2022), providing valuable information
and a vast repository of data which contributes to greater transparency within the industry
(Eichholtz et al., 2011). There is a debate about the portfolio effects of international
Journal of
Property
Investment &
Finance
555
Get this document and AI-powered insights with a free trial of vLex and Vincent AI
Get Started for FreeStart Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
