Bridge over ocean
1 May 1992 Financial Analysts Journal Volume 48, Issue 3

The Effect of Asset Class Maintenance Costs on Optimal Asset Allocation

  1. Richard A. Crowell
  2. G. Leslie Smith-Britto

Many standard portfolio optimization models favor real estate because of its low standard deviation and low correlations with other asset classes. However, real estate is a relatively illiquid investment, hence may pose problems for a pension fund faced with significant payouts. Downsizing of the plan participant base, for example, may force the fund to sell off its more liquid assets, leaving residual participants over allocated to real estate.

The asset class maintenance cost model recognizes that portfolio optimization must take into account the cost of exit from an asset. The model adjusts the expected return to each asset class by incorporating into holding period returns the costs of liquidation. It recognizes that the costs of maintaining an asset allocation constitute an ongoing impairment of return, rather than a one-time event.

At risk levels in the range of 10% to 12%, for example, a standard optimization model might suggest real estate allocations of 30% to 31% over a five-year period. The maintenance costs of real estate, however, are likely to lower significantly its annual expected return. At an exit discount from appraised value of 15%, for example, the return is reduced to the point where real estate has no place in efficient portfolios. Even if the real estate exit-price impairment is only 5%, the maximum allocation to real estate, given realistic constraints on all asset class allocations, is only 20%.

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