2. “Public and Private Real Estate: Performance Implications for Asset Allocation,” Ch. 15,
Real Estate Investment Trusts, David Geltner and Joe V. Rodriguez (McGraw Hill, 1998)
Purpose:
To test the candidate’s ability to evaluate the addition of real estate to an investment portfolio in the
context of modern portfolio theory.
LOS: The candidate should be able to
“Real Estate Investment Performance and Portfolio Considerations” (Session 11)
• evaluate the shortcomings of the various means of measuring real estate returns.
“Public and Private Real Estate: Performance Implications for Asset Allocation” (Session 11)
• criticize the way data are analyzed in property markets;
• evaluate the usefulness of the main real estate indexes;
• compare the risk–return profile of real estate to that of the other investment categories;
• prepare a summary of the problems in using real estate in the context of modern portfolio theory
(MPT);
• support a rationale in the MPT framework for including real estate in a portfolio.
Guideline Answer
Because of the thin trading prevalent in property markets, return data for private real estate have
been based on appraised values. Appraisal-based valuations are inevitably subject to lagging and
smoothing across time. In addition, data on real estate transactions are incomplete. Many costs are
not included (e.g. transaction costs, management fees) and leverage is not considered. These and
other data problems cause returns from real estate, as measured by mean-variance models, to appear
to be higher, with less volatility and lower correlation with other asset classes, than is actually the
case.
In addition, the private real estate market is not informationally efficient, which means that short-
term return statistics should not be used for long-term modern portfolio theory (MPT) analysis. To
properly conduct portfolio analysis for medium- to long-term horizon investors, MPT analysis must
be applied using long-term return statistics. Unfortunately, these data do not exist in sufficient
quantity or quality for direct real estate investments. Consequently, MPT analysis using short-term
return statistics biases the role of private real estate for a long-horizon investor and should not be
used for long term investment decisions.
In view of the above weaknesses associated with real estate return and risk data, the 40 percent
allocation to direct real estate investments suggested by the consultant is too high.
Level III: Question 21
Topic: Ethics
Minutes: 16
Readings:
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