Advanced property portfolio analysis uses modern portfolio theory, which is based on the Markowitz model.
The Markowitz model is an optimization model that requires as basic inputs, expected returns, risk and correlation measures for all the assets included in the portfolio. The model derives optimal portfolio compositions in terms of percentage allocations of available funds to selected investment opportunities. In the case of real estate these investment opportunities are properties. In particular, the Markowitz model can be used to derive the minimum-risk portfolios for given levels of return and the maximum-return portfolios for given levels of risk.
Investment Universe
In the world of the Markowitz model the investment universe is the group of available investment opportunities. However, given that the use of the Markowitz model requires the use of compatible return, risk and pairwise correlation measures, the investment universe for applying this model can include only investment opportunities for which such measures can be produced. Thus for example, in applying the Markowitz model for real estate portfolios, we can not include available investment opportunities that refer to specific properties because it is difficult if not impossible to derive scientifically sound and compatible return and risk measures for each specific property opportunity. For the scientific derivation of such measures we need to have historical investment performance for each property.
Give the data requirements of the Markowitz model, it is practically applicable mostly at the metropolitan area and property type levels. This is feasible because historical indices of real estate investment performance for the 50 largest metropolitan areas and four major property types (office, retail, industrial and apartments are available from various vendors specialized in collecting and processing such data. Thus, the investment universe for the application of the Markowitz model in real estate may include many opportunities specified in metropolitan area/property type dimensions (for example, Dallas office, Houston office, Atlanta Retail, etc.).
Return and Risk Measures
Early applications of the Markowitz model in property portfolio analysis focused on portfolios including the four major property types at the national level. The return and risk measures, as well as pairwise correlation coefficients, were derived using historical return data taken from the database of the
National Council of Real Estate Investment Fiduciaries (NCREIF). Such models verified that the argument that diversification of real estate portfolios across property types does provide diversification benefits that help reduce portfolio risk. Other applications have focused on the diversification benefits across locations using measures of economic performance.
It should be noted that real estate return and risk measures derived through typical statistical procedures from historical data may be problematic when using the Markowitz model, because it is assumed that their underlying probability distribution is normal. In other words, the Markowitz model mathematics assume that the return measures that enter the model are normally distributed around their mean. According to empirical work (Young and Graff, 1995), however, real estate returns are not normally distributed around their mean.
|
Search Our Over 500-Page Website!
|
Search Our Over 500-Page Website!
Related Posts
Property Portfolio Strategies
Property Portfolio Management
Leveraged IRR Calculation
Discounted Cash Flow Model
Real Estate Return Measures
Return from Property Portfolio Analysis to Investment Analysis
