Optimal composition of hybrid/blended real estate portfolios
| DOI | https://doi.org/10.1108/JPIF-04-2018-0022 |
| Pages | 20-41 |
| Published date | 22 August 2018 |
| Date | 22 August 2018 |
| Author | Frank Kwakutse Ametefe,Steven Devaney,Simon Andrew Stevenson |
| Subject Matter | Property valuation & finance,Property management & built environment |
Optimal composition of hybrid/
blended real estate portfolios
Frank Kwakutse Ametefe and Steven Devaney
Department of Real Estate & Planning, Henley Business School,
University of Reading, Reading, UK, and
Simon Andrew Stevenson
Department of Real Estate, University of Washington, Seattle, Washington, USA
Abstract
Purpose –The purpose of this paper is to establish an optimum mix of liquid, publicly traded assets that
may be added to a real estate portfolio, such as those held by open-ended funds, to provide the liquidity
required by institutional investors, such as UK defined contribution pension funds. This is with the objective
of securing liquidity while not unduly compromising the risk-return characteristics of the underlying asset
class. This paper considers the best mix of liquid assets at different thresholds for a liquid asset allocation,
with the performance then evaluated against that of a direct real estate benchmark index.
Design/methodology/approach –The authors employ a mean-tracking error optimisation approach in
determining the optimal combination of liquid assets that can be added to a real estate fund portfolio. The
returns of the optimised portfolios are compared to the returns for portfolios that employ the use of either cash
or listed real estate alone as a liquidity buffer. Multivariate generalised autoregressive models are used along
with rolling correlations and tracking errors to gauge the effectiveness of the various portfolios in tracking
the performance of the benchmark index.
Findings –The results indicate that applying formal optimisation techniques leads to a considerable
improvement in the ability of the returnsfrom blended real estate portfolios to track the underlying real estate
market. This is the case at a number of different thresholds for the liquid asset allocation and in cases where a
minimum return requirement is imposed.
Practical implications –The resultssuggest that real estatefund managers can realisethe liquidity benefits
of incorporating publicly traded assets into their portfolios without sacrificing the ability to deliver real
estate-likereturns. However, in order to do so, a wider range of liquid assetsmust be considered, not just cash.
Originality/value –Despite their importance in the real estate investment industry, comparatively few
studies have examined the structure and operation of open-ended real estate funds. To the authors’
knowledge, this is the first study to analyse the optimal composition of liquid assets within blended or hybrid
real estate portfolios.
Keywords Tracking error, Open-ended funds, Real estate liquidity, Portfolio optimization,
Blended real estate, Defined contribution pensions
Paper type Research paper
Introduction
Unlisted real estate funds are an important part of many mature property markets around
the world and have grown significantly in number and assets under management in the last
two decades. Yet, despite this, there is still relatively little academic research on such funds,
either on their structure and operation or as an option for gaining exposure to real estate as
an asset class. Open-ended funds, in particular, are a potentially attractive route for
investors that desire exposure to a diversified pool of real estate investments while holding
units that are reasonably liquid. However, the performance and liquidity of such funds has
come into sharper focus in recent years. For instance, in the UK, the ability of investors to
sell their holdings in some open-ended funds has been restricted following market shocks
(Forbes and Cartwright, 2012, 2017).
This makes questions around the degree of liquidity that such funds can offer, and the
means by which they can do so, important issues for research. Open-ended fund units are
not normally traded on a secondary market. Instead, units are normally bought or sold
directly from the fund itself. In order to facilitate such trades, open-ended funds typically
Journal of Property Investment &
Finance
Vol. 37 No. 1, 2019
pp. 20-41
© Emerald PublishingLimited
1463-578X
DOI 10.1108/JPIF-04-2018-0022
Received 3 April 2018
Revised 6 June 2018
Accepted 18 July 2018
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1463-578X.htm
20
JPIF
37,1
hold significant amounts of cash in the portfolio, for which Table AI provides evidence in
respect of UK funds. Yet cash acts as a drag on fund performance in most market
conditions, reducing the returns achieved and thus the ability of the fund to match the
performance of the underlying real estate market (Frodsham, 2012). While holding more
cash enables a fund to redeem units more easily in downturns or following shocks, it also
reduces its attractiveness to investors seeking real estate exposure.
In this context, this paper examines the implications of open-ended real estate funds
holding different types of liquid assets in their portfolios alongside direct real estate. Such
portfolios are called either blended or hybrid real estate portfolios, as they do not consist
solely of direct real estate investments. Formal optimisation procedures are used to
determine an optimal mix of liquid assets that might be held, with the aim of finding
portfolios that replicate closely the performance of the underlying direct real estate market.
The performance of these optimal portfolios is then compared to that of portfolios which use
only a single pre-determined liquid asset, such as cash, to provide the liquidity that is
necessary for operation of the fund. The findings suggest that holding a mix of liquid assets
could be more effective than holding cash in isolation.
This discussion does not imply that liquidity is a priority for all investors in real estate or
even for all investors in open-ended real estate funds. For some investors in open-ended funds,
restrictions on liquidity through minimum notice periods and exit fees are perceived to offer
protection (Timmermans, 2009). Nonetheless, there has been increased emphasis on liquidity by
numerous parties such as regulatory agencies, investment managers, pension trustees and
consultants following the 2007–2009 global financial crisis. At the same time, the low yield
environment following the crisis has raised interest in real estate and other alternative asset
classes as a means of meeting performance objectives. Thus, investors have been faced with the
challenge of increasing their exposure to less liquid asset classes without sacrificing liquidity.
This paper contributes to the discussion of how real estate funds need to be structured to
deal with the increased emphasis on liquidity while retaining the essential performance
attributes of private real estate as an asset class. The goal is to add liquid, tradable assets to
a direct real estate portfolio without altering the risk-return profile of the portfolio
significantly. The paper begins by discussing literature on blended solutions in both real
estate and other private asset markets before outlining the methods adopted to find optimal
blended portfolios in a real estate context. The data used are then discussed before results
and findings are presented, with the final section concluding on the implications of the
findings and the areas for further research.
Literature review
Liquidity is a multifaceted concept for which a variety of proxy measures exist, none of
which capture all of its dimensions (Ametefe et al., 2016). Here, liquidity refers to the ability
of investors to buy or sell assets quickly, at low cost and with minimal loss in value from
executing the trade. Liquidity is a relative concept, with private (direct) real estate
investments seen as comparatively illiquid owing to their high transaction costs, lengthy
and uncertain trading times, and low frequency of transactions. In the absence of active
secondary markets, real estate funds that want to offer greater liquidity to investors must
do so by holding other assets in addition to private real estate so that demands to exit the
fund can be satisfied in a timely manner. This has been achieved traditionally by holding
cash balances, but the use of public (or listed) real estate investments to facilitate greater
liquidity has been explored by several studies.
Blending direct and listed real estate investments
Early studies into the benefits of including listed real estate in US direct real estate portfolios
included Giliberto (1990), Giliberto and Testa (1990) and Stevenson (2001). These studies
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Hybrid/
blended real
estate
portfolios
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