Optimizing the Real Estate Allocation in Institutional Portfolios

Oct.17.10 | About: Vanguard REIT (VNQ)

Many pension funds and other institutional investors facing limited returns from the stock and bond segments of their portfolios are increasing their allocations to real estate to help meet their overall investment targets. A question that NAREIT frequently gets from these investors is how should they divide their real estate allocations among publicly traded equity REITs and private equity real estate funds following core, value-added and opportunistic strategies to optimize returns and minimize volatility.

Of course, all investors have different requirements, but a good rule of thumb is this: about one-third in publicly traded REITs, one-third in core funds, and one-third in opportunistic funds (with none in value-added funds).

That general result comes from Markowitz mean-variance portfolio optimization using data from the returns to all four ways of investing in real estate from the beginning of 1992 through the first quarter of 2010 (the latest period for which data are available for value-added and opportunistic funds).

You can do this analysis yourself if you have portfolio optimization software.

Equity REIT total returns are available at NAREIT’s website (see excel file here); subtract about 4 basis points each month for investment manager fees and expenses. Net returns for core, value-added, and opportunistic funds are collected by the National Council of Real Estate Investment Fiduciaries through the NCREIF/Townsend Fund Indexes, though they’re available only to members.

During the period 1992-2010q1, net returns averaged 3.01% per quarter for publicly traded equity REITs, 1.33% for core funds, 1.15% for value-added funds, and 2.04% for opportunistic funds. The measured covariance matrix looked like this:

0.0109

0.0006

0.0010

0.0021

0.0006

0.0011

0.0014

0.0017

0.0010

0.0014

0.0022

0.0026

0.0021

0.0017

0.0026

0.0038

Click to enlarge

Here are some illustrative results. For an investor seeking a target net return averaging 7.5% per year, the optimized portfolio would have been allocated 58.8% to core funds, 25.8% to REITs, and 15.4% to opportunistic funds.

For an investor constrained from investing more than 30% in publicly traded REITs, the optimized portfolio would also have put 41.6% in core funds and 28.4% in opportunistic funds; the average return would have been 8.15% per year.

For an investor seeking to maximize risk-adjusted returns (the Sharpe ratio), the optimized portfolio would have been invested 35.0% in REITs, 21.0% in core funds, and 44.0% in opportunistic funds.

I’ll report more results from this analysis in future posts; feel free to suggest new ways of looking at the data.

Disclosure: Author is long Vanguard REIT Index Fund and ING Real Estate Fund

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.