Many studies contend that pension funds should optimally allocate at least 20 per cent of their total assets to real estate. But actual pension funds’ aggregate investment in equity real estate constitutes approximately 4 per cent of assets. Why has practice failed to evolve even remotely in line with portfolio construction models?

Using a real estate return series derived from continuous-auction-market trading of real estate equity interests (rather than the appraisal-based returns typically used) and expected returns derived from a simple equilibrium model (rather than mean historical returns), this study finds that most efficiently diversified balanced portfolios have real estate investments in the range of 10 to 15 per cent of total assets. This is well below the figures arrived at in prior studies and in line with the allocations of a number of large pension funds. It is nevertheless substantially greater than the actual percentage of real estate held by U.S. pension funds in aggregate.

A simple equilibrium pricing model is obviously superior to ignoring equilibrium pricing altogether. But it is inadequate when real estate is included along with marketable securities. Factors peculiar to real estate investment—including taxes, limited information availability, transaction costs, limited trading liquidity and largely indivisible ownership interests—must be considered along with the risk characteristics included in simple equilibrium models.