Real estate portfolio construction for a multi-asset portfolio

AuthorJon R.G.M Lekander
Publication Date07 Sep 2015
Real estate portfolio construction
for a multi-asset portfolio
Jon R.G.M. Lekander
Department of Real Estate and Construction Management,
Royal Institute of Technology, Stockholm, Sweden
Purpose The purpose of this paper is to explore how tenant end demand dependence and investment
market segmentation, as estimated through sector type, impacts real estate portfolio strategy in the context
of the multi-asset portfolio.
Design/methodology/approach The analysis is performed for six investor domeciles, for
domestic and international investments over several cycles. The analysis is performed in a mean
variance framework.
Findings The findings are consistent with the hypothesis that an investor benefits from investing in
real estate assets where end demand is dependent on local factors rather than global factors.
Practical implications The efficiency of the overall multi-asset portfolio benefits from a deeper
understanding of how the real estate portfolio is constructed. Locally dependent real estate, i.e. real
estate that is dependent on local economic factors, tends to better support the overall portfolio than do
real estate that is dependent upon global factors.
Originality/value The paper contributes to the broader knowledge through extending earlier
studies using similar methodology by extending the data series to cover the impact of the latest global
financial crises, as well through extending the knowledge how the real estate portfolio should be
constructed to better support the overall objectives of the multi-asset portfolio.
Keywords Asset allocation, Real estate, Globally dependent real estate, Locally dependent real estate,
Real estate portfolio construction, Sector strateg y
Paper type Research paper
1. Introduction
The controversy over the role of real estate in the context of asset allocation in
institutional portfolios continues to attract a great deal of interest. There is an implicit
consensus that real estate plays a role in asset allocation, but there is a divergence of
opinion on what that allocation is and its purpose. There is also a diverg ence on how
various costs, such as illiquidity, information asymmetries and management affect the
attractiveness of the asset class. This discussion will continue, which will foster an
improved understanding of the complexities of the asset class.
As the research of real estate contribution typically uses real estate market indices,
it is implicitly assumed that investors hold market portfolios. Little research has been
conducted on how the real estate portfolio should be constructed to support the overall
objective of a multi-asset portfolio. The goal here is to investigate the sub-problem of
formulating an efficient real estate strategy that best supports the portfolios overall
objective. The rationale for investigation is that certain types of real estate are more
subject to local factors, whereas other types are more subject to global factors.
The analysis builds on and extends that of Hoesli et al. (2004) but broadens the
length of the time series and the depth of analysis as they pertain to the real estate
portfolio. The purpose is to investigate how the composition of a real estate portfolio
affects the ability to achieve risk diversification when management costs are taken into
account and after removing the assumption that investors can only buy a rea l estate
Journal of Property Investment &
Vol. 33 No. 6, 2015
pp. 548-573
©Emerald Group Publishing Limited
DOI 10.1108/JPIF-02-2015-0013
Received 8 February 2015
Revised 5 July 2015
Accepted 6 July 2015
The current issue and full text archive of this journal is available on Emerald Insight at:
market portfolio. The analysis contributes to the body of knowledge by exploring how
the type of underlying tenant demand type affects the portfolio composition problem
for real estate investors and thus how real estate strategies should be fashioned to more
effectively support overall portfolio objectives.
The researchers aim in this paper is therefore twofold:
(1) to present the what general types of real estate support different overall
strategies for the multi-asset portfolio best; and
(2) to extend the data set of historical returns with the effects of the financial crisis
to judge the effect on the allocation to real estate.
The next section contains a literature review, after which Section 3 offers a description
of the model. In the Section 4, the data and parameter assumptions are discussed, after
which the analysis and results are presented. The paper concludes with a summary and
discussion of the results.
2. Literature revie w
Kennedy and Baum (2012) define asset allocation as the process in which allocations
between discernible and distinguishable asset classes that maximize the probability of
achieving the investors return objectives is determined. It is well understood that real
estate, being a discernible and distinguishable asset class, plays a role in the asset
allocation of institutional portfolios. However, there are several views on what this role
could entail. In general, real estate can fulfil four potential roles: an asset class reducing
overall portfolio variance, a liability matching asset class, an inflation hedge and a
return enhancer.
The role thatinvestors expectreal estate to play in themulti-asset portfolio dependson
the methodology used for determining the asset allocation, how the investment universe is
defined and what instruments the investor chooses. Kennedy and Baum observe that
different objectives and perceptions of risk lead to different results and that real estate in
this context, being a complex, unstandardized asset class, can be seen as fulfilling different
roles. These various roles are determined by what type of real estate the investor
purchases, such as development assets for repositioning together with the use of leverage.
From this, it follows that there are multiple answers regarding the role real estate, or any
other asset class sharing similar characteristics, can perform in the portfolio.
One reason for viewing real estate as potentially fulfilling various roles depending
on the overall portfolios objective is the complexity and heterogeneity of assets.
Ang (2012) explores the characteristics of real estate in the context of its real asset
characteristics along with real estates role in the asset allocation puzzle. He concludes
that real estate is different from other asset classes in several respects: the idiosyncratic
risk, the heterogeneity of the assets and the requirement to actively manage real estate
holdings. Ang also points out the difficulty of including real estate in any asset
allocation model on par with stocks and bonds because direct real estate total returns
are not returns in the same sense as are total returns for the other asset classes. This is
because real estate total returns are not transaction based nor is there a way t o measure
the whole market. Ang does not say that real estate has no role to play but rather that
the only return derived from real estate measured on the same frequency as the return
on mature asset classes is the income return.
Real estate is sufficiently homogeneous to be easily defined as an asset class and
does not require harmonization and standardization through securitization to be
Real estate

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