The Case for a Diversified Real Estate Portfolio

2/6/2011 | By Matt Bechard
NAREIT has posted a white paper on REIT.com called "Optimizing Risk and Return in Pension Fund Real Estate." The research paper shows how pension fund investors can increase returns and lower the volatility of their equity real estate portfolios by allocating about one-third of them to publicly-traded REITs.

As an additional portfolio planning tool, NAREIT has created a real estate portfolio optimizer on REIT.com. The optimizer is an interactive, software-driven device we created to enable investors to compare returns, volatility and Sharpe ratios – risk-adjusted returns – of various real estate portfolio allocation strategies.

It calculates the actual historical performance of portfolios with various allocations to publicly traded equity REITs and to private equity core, value-added and opportunistic funds.

"Investors just enter the percentage allocations they want for each of the four investments," NAREIT Senior Vice President of Research and Industry Information Brad Case said. "For example, core real estate investments are generally regarded by institutional investors as the safest, and a large amount of pension fund investment flowed into core funds in the past year."

As an example, Case highlighted a 100-percent core portfolio, which produced average annual net returns of 5.5 percent, volatility of 6.8 percent and a Sharpe ratio of 0.351.

"You can tell this portfolio performance was sub-optimal, because the portfolio symbol falls below the efficient frontier curve on the optimizer," Case said. "That means that, with a different allocation including REITs, investors could have achieved even lower risk—or higher returns with no additional risk."

Based on research Case reviewed, he said a more fairly typical institutional real estate portfolio has only 9 percent invested in REITs along with 50 percent core funds, 19 percent opportunistic and 22 percent value-added. This portfolio produced average annual net returns of 6.4 percent with volatility of 8.1 percent for a Sharpe ratio of 0.409.

"That's a better risk-adjusted return than core funds alone, but it's still sub-optimal – largely because the REIT allocation is too small," Case said.

A more effective allocation to REITs if an investor wants to optimize the real estate portfolio would be about a quarter to a third, or more. Case said when you increase the REIT allocation to 25 percent; the core allocation to 70 percent; and the opportunistic allocation to 5 percent, with no value-added allocation, the optimized portfolio boosts average annual net returns to 7.2 percent from 6.4 percent and holds volatility steady at 8.1 percent, giving us a much better Sharpe ratio of 0.498.

As for investors who are seeking even higher returns from their real estate portfolios – in the neighborhood of 8 percent, Case discussed a portfolio with 30 percent REITs; 50 percent core funds and 20 percent opportunistic funds.

"It produces average annual net returns of 7.9 percent with 9.4 percent volatility, and a Sharpe ratio of 0.507," Case said.

The data behind the optimizer is based on 18.5 years of quarterly net returns – from the first quarter of 1992 through the second quarter of 2010 – for REITs and the three types of private equity real estate funds, Case said. The optimizer can provide performance data for more than 176,000 portfolio combinations for this period.

Investors can work with the optimizer themselves and find complete information on it at REIT.com/optimize.

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