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1 March 2014 CFA Institute Journal Review

Portfolio Strategy and Structure Take Center Stage: “How, What, Where, and When?” Replace “Why?” (Digest Summary)

  1. Thomas M. Arnold, CFA

A review of real estate research from the past 10 years illustrates the unique issues posed by real estate as an investment. The authors separate the research into issues concerning real estate as an asset class and how real estate investment is implemented in a portfolio. As an asset class, the risk associated with real estate is difficult to assess because of illiquidity and an unresolved issue of using appraised values versus actual transaction values. Investment-implementation issues emerge because index benchmarks are not necessarily appropriate for determining the amount of allocation because the index construction differs from the actual investment opportunities available.

What’s Inside?

The authors review and synthesize real estate research from the past 10 years. Real estate is a popular alternative asset class, but it cannot be conveniently defined as a unified asset class and does not readily fit into risk assessment in the same way as publicly traded securities. The authors divide real estate issues into two categories: asset-class issues in terms of risk and return and allocation-implementation issues.

How Is This Research Useful to Practitioners?

As an asset class, real estate differs from publicly traded securities in that traditional risk measurement, such as price volatility, does not readily apply. Real estate tends to be illiquid, and there are issues concerning the appropriateness of appraised values versus transaction values. Although new indices have improved transparency, the issues of illiquidity and appraisal versus transaction values are still significant.

Real estate tends to be a large investment, which may interfere with the ability to diversify, which, in turn, can affect risk. Furthermore, newer types of investors (e.g., defined contribution plans) require daily valuations, which are generally not available from the large market of real estate investment by private equity.

Newer techniques for assessing risk separate risk into risk–return “buckets” based on performance rather than asset class. Real estate investment, even when separated using the quadrant approach (four designations of real estate based on public equity, public debt, private debt, and private equity), still does not conveniently fit into a particular bucket. Essentially, what is often considered a homogenous type of investment is simply not homogenous in many respects.

For the implementation of a real estate investment, allocations based on indices will possibly be flawed because most real estate investment involves significant leverage (particularly if through a private equity fund), whereas most indices do not contain leverage. Furthermore, newer types of investors and creditors from foreign entities may be influencing real estate investment in a manner that is still not understood completely.

Practitioners will benefit from understanding that risk assessment with real estate may involve risk that is not readily diversifiable. New derivative products may help address this problem in the future, but current issues tend to involve illiquidity and the valuation of real estate using appraised versus transaction prices. Practitioners should also be aware of the limitations of real estate indices for generating allocations and as benchmarks. Indices do not capture much of the leverage used in real estate investments and also have the issue of appraisal versus transaction valuation.

How Did the Authors Conduct This Research?

The authors reviewed and synthesized research from the past 10 years.

Abstractor’s Viewpoint

The article is very thought provoking in breaking down the issues that apply to real estate investment from a portfolio manager’s perspective. As an asset class, real estate does not appear to be very homogenous and may also be changing as new types of investors, investment needs, and derivative securities continue to emerge.

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