Realty Deep Analysis Part 1

Chapter 21
MACRO-LEVEL REAL ESTATE

INVESTMENT ISSUES
2014 OnCourse Learning. All Rights

Reserved.
21.2 Basic Mean-Variance Portfolio Theory

"MODERN PORTFOLIO THEORY"
(aka "Mean-Variance Portfolio Theory", or Markowitz Portfolio
Theory Either way: MPT for short)
DEVELOPED IN 1950s (by MARKOWITZ, SHARPE, LINTNER)
(Won Nobel Prize in Economics in 1990.)
WIDELY USED AMONG PROFESSIONAL INVESTORS
FUNDAMENTAL DISCIPLINE OF PORTFOLIO-LEVEL
INVESTMENT STRATEGIC DECISION MAKING.
(See text Appendix 21A (or slides at end) for intro/review of portf return statistics.)
Reserved.
21.2:
FOR RIGOROUS QUANTIFICATION,
PORTFOLIO THEORY ASSUMES:
YOUR OBJECTIVE FOR YOUR OVERALL WEALTH
PORTFOLIO IS:
MAXIMIZE EXPECTED FUTURE RETURN
MINIMIZE RISK IN THE FUTURE RETURN

Reserved.
21.2.1. Investor Preferences & Dominant Portfolios
Utility preference surface for return & risk:

RISK-AVERSE INVESTOR
P
RETURN
RISK
THE CONTOUR LINES (UTILITY ISOQUANTS) STEEPLY RISING IN RETURN

OVER RISK:
RISK-AVERSE INVESTOR WANTS MUCH MORE RETURN TO COMPENSATE
FOR A LITTLE MORE RISK.
Reserved.
21.2.1. Investor Preferences & Dominant Portfolios
Utility preference surface for return & risk:

RISK-TOLERANT INVESTOR
RETURN
RISK
THE CONTOUR LINES (UTILITY ISOQUANTS) SHALLOWER:

LESS RISK-AVERSE INVESTOR NEEDS LESS RETURN TO COMPENSATE FOR
A MORE RISK.
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21.2.2
BOTH INVESTORS WOULD AGREE THEY PREFER POINTS TO THE

"NORTH" AND "WEST" IN THE RISK/RETURN SPACE. THEY BOTH
PREFER POINT "P" TO POINT "Q".
P DOMINATES Q.
INDEPENDENT OF RISK PREFERENCES.
BOTH CONSERVATIVE AND AGGRESSIVE INVESTORS WOULD
AGREE ABOUT THIS.
PORTFOLIO THEORY IS ABOUT HOW TO AVOID INVESTING IN
DOMINATED PORTFOLIOS.
DOMINATES
"Q"
RETURN
P
DOMINATES
"Q"
Q
DOMINATED
BY
"Q"
RISK
Exh.21-3: PORTFOLIO THEORY TRIES TO
MOVE INVESTORS FROM POINTS LIKE "Q"
2014 OnCourse Learning.TO
AllPOINTS
Rights LIKE P ".
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6
Section 21.2.2
III. PORTFOLIO THEORY AND DIVERSIFICATION...
"PORTFOLIOS" ARE "COMBINATIONS OF ASSETS".
PORTFOLIO THEORY FOR (or from) YOUR GRANDMOTHER:
DONT PUT ALL YOUR EGGS IN ONE BASKET!
WHAT MORE THAN THIS CAN WE SAY? . . .
(e.g., How many eggs should we put in which baskets.)
In other words,
GIVEN YOUR OVERALL INVESTABLE WEALTH, PORTFOLIO THEORY TELLS YOU HOW
MUCH YOU SHOULD INVEST IN DIFFERENT TYPES OF ASSETS. FOR EXAMPLE:
WHAT % SHOULD YOU PUT IN REAL ESTATE?
WHAT % SHOULD YOU PUT IN STOCKS?
TO BEGIN TO RIGOROUSLY ANSWER THIS QUESTION, CONSIDER...

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Making the analysis more formal & rigorous

AT THE HEART OF PORTFOLIO THEORY ARE TWO BASIC
MATHEMATICAL FACTS:
1) PORTFOLIO RETURN IS A LINEAR FUNCTION OF THE ASSET
WEIGHTS:
IN PARTICULAR, THE PORTFOLIO EXPECTED RETURN IS A
WEIGHTED AVERAGE OF THE EXPECTED RETURNS TO THE
INDIVIDUAL ASSETS. E.G., WITH TWO ASSETS ("i" & "j"):
rp = ri + (1-)rj
WHERE i IS THE SHARE OF PORTFOLIO TOTAL VALUE INVESTED
IN ASSET i.
e.g., If Asset A has E[rA]=5% and Asset B has E[rB]=10%, then a

50/50 Portfolio (50% A + 50% B) will have E[rP]=7.5%.
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THE 2ND FACT:

2) PORTFOLIO VOLATILITY IS A NON-LINEAR FUNCTION OF THE
ASSET WEIGHTS:
SUCH THAT THE PORTFOLIO VOLATILITY IS LESS THAN A
WEIGHTED AVERAGE OF THE VOLATILITIES OF THE INDIVIDUAL
ASSETS. E.G., WITH TWO ASSETS:
sP = SQRT[ w(si) + (1-w)(sj) + 2w(1-w)sisjCij ]
< wsi + (1-w)sj , where: s=StDev, C=correl

WHERE si IS THE RISK (MEASURED BY STD.DEV.) OF ASSET i.
e.g., If Asset A has StdDev[rA]=5% and Asset B has

StdDev[rB]=10%, then a 50/50 Portfolio (50% A + 50% B) will
have StdDev[rP] < 7.5% (conceivably even < 5%).
This is the beauty of Diversification. It is at the core of Portfolio Theory. It
is perhaps the only place in economics where you get a free lunch: In this
case, less risk without necessarily reducing your expected return!
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Heres a picture of these two mathematical facts:

N
r P = wn r n
e.g., where P is { (1/2)A & (1/2)B }
n=1
Expected
Return
VAR P wi w j COVij
I 1 J 1
10%
7.5%
5%
A
5%
10%
Volatility
< 7.5%
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10
This Diversification Effect is greater, the lower is the correlation among the
assets in the portfolio.
NUMERICAL EXAMPLE . . .
SUPPOSE REAL ESTATE HAS:
EXPECTED RETURN
= 8%
RISK (STD.DEV)
= 10%
SUPPOSE STOCKS HAVE:

EXPECTED RETURN
= 12%
RISK (STD.DEV)
= 15%
THEN A PORTFOLIO WITH SHARE IN REAL ESTATE & (1-) SHARE IN STOCKS WILL
RESULT IN THESE RISK/RETURN COMBINATIONS, DEPENDING ON THE CORRELATION
BETWEEN THE REAL ESTATE AND STOCK RETURNS:
C = 100%
C = 25%
C = 0%
C = -50%
rP
sP
rP
sP
rP
sP
rP
sP
0%
12.0% 15.0% 12.0% 15.0% 12.0% 15.0% 12.0% 15.0%
25%
11.0% 13.8% 11.0% 12.1% 11.0% 11.5% 11.0% 10.2%
50%
10.0% 12.5% 10.0% 10.0% 10.0%
9.0% 10.0%
6.6%
75%
9.0% 11.3%
9.0%
9.2%
9.0%
8.4%
9.0%
6.5%
100%
8.0% 10.0%
8.0% 10.0%
8.0% 10.0%
8.0% 10.0%
where:
C = Correlation Coefficient between Stocks & Real Estate.
(This table was simply computed using the formulas noted previously.)

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11
This Diversification Effect is greater, the lower is the correlation among the
assets in the portfolio.
Correlation = 100%
Portf Exptd Return
12%
11%
1/4 RE
10%
1/2 RE
9%
3/4 RE
8%
9%
10%
11%
12%
13%
Portf Risk (STD)
14%
15%
14%
15%
Correlation = 25%
Portf Exptd Return
12%
11%
1/4 RE
10%
1/2 RE
3/4 RE
9%
8%
9%
10%
11%
12%
13%
Portf Risk (STD)

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12
21.2.2 Effect of diversification (Exhs.21-4&5)

The diversification effect is greater the less correlated are the assets
Large & Small Stocks (+71% correlation): Each dot is one year's
returns.

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13
21.2.2 Effect of diversification (Exhs.21-4&5)

The diversification effect is greater the less correlated are the assets
Bonds & real estate (0% correlation): Each dot is one year's returns.

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14
Exh.21-5a: For example, a portfolio of 50% large stocks & 50% small stocks would
not have provided much volatility reduction during 1970-2010 (from large stk vol 18%
& small stk vol 23% to half/half vol 19%) :
1970-2010 Sm/Lg Stk correl = +71%

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15
Exh.21-5b: Here the portfolio of 50% bonds & 50% real estate would have provided
more diversification during 1970-2010, with less volatility than either asset class alone
even though a very similar avg total return:
1970-2010 Bd/RE correl = 0%

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16
KEY POINT THAT YOU CAN ALREADY SEE WITHOUT FANCY

MATH
Given:
Risk that matters to investor is risk in overall
wealth ,
Therefore:
Risk that matters in investments (assets) is
covariance with overall wealth (contribution to
overall wealth volatility);
Not the assets own volatility (Stdev) per se
(e.g., if investor portf primarily stocks & bonds, & if real
estate has low correlation with stocks & bonds, then
R.E. volatility may not matter to investor; because it may
not contribute much to investor's wealth volatility.)
N
VAR P wi w j COVij
Covariance = Stdev(i)*Stdev(j)*Correl(I,j)
I 1 J 1

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17
21.2.3 Perceived Role of Real Estate in the Mixed-Asset Portfolio

Much recent bemoaning the lack of diversification between real estate
and stocks during the big 2008 crash.
Everything went down

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18

and stocks during the big 2008 crash. But in the big picture
(Northeast & Southwest quadrants Lack of diversification.)
In which
quadrant
do you
care
about
lack of
diversification?...
Though hard data is lacking, we would probably have to go back a further 30+ yrs to find a third double-down year:
1/30 chance any one year both down
19


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20


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21

Big Bear Events:

> -20% decline
41 yrs history:
5 LgStk, 7
SmStk, 3 RE, 2
LTGBnd;
2 coincide
across all
Fat tails (non-normality) can be represented by big bear events (asset

class down > -20%). How does R.E. compare?...
22

Fat tail magnitude: Real estate avg big bear 2/3 that of
stocks, half the frequency, and more regular (predictable)
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23

Of the 8 bears listed here, only 2 afflicted all three risky asset
classes (and actually also bonds too).
Two market-wide big bears, separated by 33 years.
(Clearly the Great Depression, 40 years earlier, also did that.)

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24
Fat tail magnitude: Real estate avg big bear 2/3 that of
stocks, half the frequency, and more regular (predictable)
Trough-to-Trough history is fair and conservative 35-year

period
25
21.2.4 STEP 1: FINDING THE EFFICIENT FRONTIER

SUPPOSE WE HAVE THE FOLLOWING RISK & RETURN
EXPECTATIONS
INVESTING IN ANY ONE OF THE THREE ASSET CLASSES WITHOUT

DIVERSIFICATION ALLOWS THE INVESTOR TO ACHIEVE ONLY ONE
OF THREE POSSIBLE RISK/RETURN POINTS

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26
INVESTING IN ANY ONE OF THE THREE ASSET CLASSES WITHOUT

DIVERSIFICATION ALLOWS THE INVESTOR TO ACHIEVE ONLY ONE OF THE
THREE POSSIBLE RISK/RETURN POINTS DEPICTED IN THE GRAPH
BELOW
Exh.21-7a:
IN A RISK/RETURN CHART LIKE THIS, ONE WANTS TO BE ABLE TO GET AS

MANY RISK/RETURN COMBINATIONS AS POSSIBLE, AS FAR TO THE
NORTH AND WEST AS POSSIBLE.
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27
ALLOWING PAIRWISE COMBINATIONS (AS WITH OUR PREVIOUS STOCKS

& REAL ESTATE EXAMPLE), INCREASES THE RISK/RETURN POSSIBILITIES
TO THESE
Exh.21-7b:

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28
FINALLY, IF WE ALLOW UNLIMITED DIVERSIFICATION AMONG ALL THREE

ASSET CLASSES, WE ENABLE AN INFINITE NUMBER OF COMBINATIONS,
THE BEST (I.E., MOST NORTH AND WEST) OF WHICH ARE SHOWN
BY THE OUTSIDE (ENVELOPING) CURVE.
Exh.21-7c:
Exh.21-7c: THIS IS THE EFFICIENT FRONTIER (IN THIS CASE OF

THREE ASSET CLASSES).
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29
EFFICIENT FRONTIER CONSISTS OF ALL ASSET

COMBINATIONS (PORTFOLIOS) WHICH MAXIMIZE
RETURN AND MINIMIZE RISK.
EFFICIENT FRONTIER IS AS FAR NORTH AND WEST
AS YOU CAN POSSIBLY GET IN THE RISK/RETURN
GRAPH.
A PORTFOLIO IS SAID TO BE EFFICIENT (i.e.,
represents one point on the efficient frontier) IF IT HAS THE
MINIMUM POSSIBLE VOLATILITY FOR A GIVEN
EXPECTED RETURN, AND/OR THE MAXIMUM
EXPECTED RETURN FOR A GIVEN LEVEL OF
VOLATILITY.
(Terminology note: This is a different definition of "efficiency"
than the concept of informational efficiency applied to asset
markets and asset prices.)
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30
SUMMARY UP TO HERE:
DIVERSIFICATION AMONG RISKY ASSETS ALLOWS:
GREATER EXPECTED RETURN TO BE OBTAINED
FOR ANY GIVEN RISK EXPOSURE, &/OR;
LESS RISK TO BE INCURRED
FOR ANY GIVEN EXPECTED RETURN TARGET.
(This is called getting on the "efficient frontier".)
PORTFOLIO THEORY ALLOWS US TO:
QUANTIFY THIS EFFECT OF DIVERSIFICATION
IDENTIFY THE "OPTIMAL" (BEST) MIXTURE OF RISKY
ASSETS
(It also allows to quantify how much it matters.)

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31
MATHEMATICALLY, THIS IS A "CONSTRAINED

OPTIMIZATION" PROBLEM
==> Algebraic solution using calculus
==> Numerical solution using computer and
"quadratic programming". Spreadsheets such as Excel
include "Solvers" that can find optimal portfolios this
way (via numerical search algorithms).
Remember: Milton Friedman told Harry

Markowitz in 1956 (HM defending his PhD
dissertation): This is not economics.
What is it?...
Optimal control, a branch of Operations
Research or Engineering Systems.
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32
Example: Given following expectations:
Assuming weights: (1/2)Stocks, (1/3)Bonds, (1/6)RE,

Portf mean (expected) return is:
r P = wST rST wBD rBD wRE rRE 12 10% 13 6% 16 7% 8.17%

Portf variance is the sum across the 9 cells:
SUM
(1/2)(1/2)(.15)(.15)(1.00)
(1/2)(1/3)(.15)(.08)(0.30)
(1/2)(1/6)(.15)(.10)(0.25)
(1/2)(1/3)(.15)(.08)(0.30)
(1/3)(1/3)(.08)(.08)(1.00)
(1/3)(1/6)(.08)(.10)(0.15)
(1/2)(1/6)(.15)(.10)(0.25)
(1/3)(1/6)(.08)(.10)(0.15)
(1/6)(1/6)(.10)(.10)(1.00)
0.0056
0.0006
0.0003
0.0006
0.0007
0.0001
0.0003
0.0001
0.0003
SQRT(0.0086) = 9.26% = Portf Volatility33
= 0.0086
MATHEMATICALLY, THIS IS A "CONSTRAINED

OPTIMIZATION" PROBLEM
Set the problem up in Excel as on the previous slide.
Invoke the Excel Solver so as to:
Find the weights (wST, wBD, wRE) such that they:
Are all positive,
Sum to 1,
Produce portf mean return rP = target return, and
They minimize the portfolio volatility.
Repeat for various different target return points to trace
out the efficient frontier.
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34
Portf Expexted Return
Let optimizer (e.g., Excel Solver) find the

portfolios (asset class shares) that trace out this
by specifying target returns,
frontier
then minimize portf vol.
Max-vol
asset class
For starting point

(left-hand edge of
area chart)
You want this.

Min-vol
asset class
Not this.
Min-vol
portf
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Portf Volatility
35
21.2.5. STEP 2: PICK A RETURN TARGET FOR YOUR OVERALL

WEALTH THAT REFLECTS YOUR RISK PREFERENCES...
E.G., ARE YOU HERE (7%)?...
Exh.21-8a:

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36
21.2.5. STEP 2: PICK A RETURN TARGET FOR YOUR OVERALL

WEALTH THAT REFLECTS YOUR RISK PREFERENCES...
OR ARE YOU HERE (9%)?...
Exh.21-8b:

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37
21.2.6
Major Implications of Portfolio Theory for Real Estate Investment
MinVar
Portf Retn
Exh.21-9: Core real estate assets typically make up a large share of

efficient (non-dominated) portfolios for conservative to moderate
return targets.
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38
21.2.7 EXPAND PORTFOLIO CHOICE SET BY ADDING

ADDITIONAL SUB-CLASSES OF ASSETS
For example, suppose we add the following expectations for an
additional sub-class of stocks (small stocks) and an additional sub-class
of real estate (REITs)
Exh.21-10a:

Reserved.
39

Reserved.
40
GENERAL QUALITATIVE RESULTS OF PORTFOLIO THEORY

1) OPTIMAL REAL ESTATE SHARE DEPENDS ON HOW
CONSERVATIVE OR AGGRESSIVE IS THE INVESTOR;
2) TYPICALLY, REAL ESTATE IS A SIGNIFICANT SHARE. (COMPARE
THESE SHARES TO THE AVERAGE U.S. PENSION FUND REAL
ESTATE ALLOCATION WHICH IS LESS THAN 5%. THIS IS WHY
PORTFOLIO THEORY HAS BEEN USED TO TRY TO GET INCREASED
PF ALLOCATION TO REAL ESTATE.)
3) REAL ESTATE APPEAL IN PORTF DUE TO LOW CORRELATION
WITH STOCKS & BONDS. (INPUT ASSUMPTIONS IN THE ABOVE
EXAMPLE DID NOT INCLUDE A HIGH RETURN OR LOW VOLATILITY FOR
R.E. THUS, LARGE R.E. SHARE IN OPTIMAL PORTF MUST NOT BE DUE TO
SUCH ASSUMPTIONS.)

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41
Another Role for Real Estate

On the Asset Side:
Real Estate is a diversifier :
Reduces asset volatility
On the Liability Side (of a defn ben PF):

Real Estate is an inflation hedge
Reduces exposure to inflation risk (COLAs, CPI-salary
creep).
Can explicitly integrate the two sides by applying

MPT to Net Assets (assets net of PV of
anticipated liabilities).
But tricky to properly include inflation risk.
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42
Section 21.3
VII. INTRODUCING A "RISKLESS ASSET"...
IN A COMBINATION OF A RISKLESS AND A RISKY ASSET, BOTH
RISK AND RETURN ARE WEIGHTED AVERAGES OF RISK AND
RETURN OF THE TWO ASSETS:
Recall:
sP = [ (si) + (1-)(sj) + 2(1-)sisjCij ]

If sj=0, this reduces to:
sP = [ (si) = si
SO THE RISK/RETURN COMBINATIONS OF A MIXTURE OF

INVESTMENT IN A RISKLESS ASSET AND A RISKY ASSET LIE ON
A STRAIGHT LINE, PASSING THROUGH THE TWO POINTS
REPRESENTING THE RISK/RETURN COMBINATIONS OF THE
RISKLESS ASSET AND THE RISKY ASSET.

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43
If either i or j is riskless . . .
E[rj]
E[ri]
si
Reserved.
sj
Volatility
44
i.e., we dont have this anymore (if A is riskless):

r P = wA rA wB rB
e.g., where P is { (1/2)A & (1/2)B }
VAR P wB wBVAR B
Expected
Return Red line is now straight
(on top of green)
10%
7.5%
5%
This is
now 0%
(not 5%
anymore)
A
5%
10%
Volatility
< 7.5%
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45
IN PORTFOLIO ANALYSIS, THE "RISKLESS ASSET"

REPRESENTS BORROWING OR LENDING BY THE INVESTOR
BORROWING IS LIKE "SELLING SHORT" OR HOLDING A NEGATIVE
WEIGHT IN THE RISKLESS ASSET. BORROWING IS "RISKLESS"
BECAUSE YOU MUST PAY THE MONEY BACK NO MATTER
WHAT.
LENDING IS LIKE BUYING A BOND OR HOLDING A POSITIVE
WEIGHT IN THE RISKLESS ASSET. LENDING IS "RISKLESS"
BECAUSE YOU CAN INVEST IN GOVT BONDS AND HOLD TO
MATURITY.

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46
SUPPOSE YOU COMBINE RISKLESS BORROWING OR LENDING

WITH YOUR INVESTMENT IN THE RISKY PORTFOLIO OF STOCKS
& REAL ESTATE.
YOUR OVERALL EXPECTED RETURN WILL BE:
rW = vrP + (1-v)rf
AND YOUR OVERALL RISK WILL BE:
sW = vsP + (1-v)0 = vsP
Where:
v = Weight in risky portfolio

rW, sW = Return, Std.Dev., in overall wealth
rP, sP = Return, Std.Dev., in risky portfolio
rf = Riskfree Interest Rate
v NEED NOT BE CONSTRAINED TO BE LESS THAN UNITY.

v CAN BE GREATER THAN 1 ("leverage" , "borrowing"), OR
v CAN BE LESS THAN 1 BUT POSITIVE ("lending", investing in bonds,
in addition to investing in the risky portfolio).
THUS, USING BORROWING OR LENDING, IT IS POSSIBLE TO
OBTAIN ANY RETURN TARGET OR ANY RISK TARGET. THE
RISK/RETURN COMBINATIONS WILL LIE ON THE STRAIGHT LINE
PASSING THROUGH POINTS rf AND rP.
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47
NUMERICAL EXAMPLE
SUPPOSE:
RISKFREE INTEREST RATE = 5%
STOCK EXPECTED RETURN = 15%
STOCK STD.DEV. = 15%
________________________________________________________
IF RETURN TARGET = 20%,
BORROW $0.5
INVEST $1.5 IN STOCKS (v = 1.5).
EXPECTED RETURN WOULD BE:
(1.5)15% + (-0.5)5% = 20%
RISK WOULD BE
(1.5)15% + (-0.5)0% = 22.5%
________________________________________________________
LEND (INVEST IN BONDS) $0.5
INVEST $0.5 IN STOCKS (v = 0.5).
(0.5)15% + (0.5)5% = 10%
RISK WOULD BE
(0.5)15% + (0.5)0% =
7.5%
___________________________________________________________

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48
NOTICE THESE POSSIBILITIES LIE ON A STRAIGHT LINE IN

RISK/RETURN SPACE . . .
RISK & RETURN COMBINATIONS USING STOCKS & RISKLESS BORROWING OR LENDING
35%
30%
EX 25%
PC
TE
D 20%
RE
TU 15%
R
N
10%
5%
BORROW
V=150%
LEND
V=100%
V=50%
V = WEIGHT IN STOCKS
V=0
0%
0%
7.5%
15%
RISK (STD.DEV.)

Reserved.
22.5%
49
BUT NO MATTER WHAT YOUR RETURN TARGET, YOU CAN DO

BETTER BY PUTTING YOUR RISKY MONEY IN A DIVERSIFIED
PORTFOLIO OF REAL ESTATE & STOCKS . . .
SUPPOSE:
REAL ESTATE EXPECTED RETURN = 10%
REAL ESTATE STD.DEV. = 10%
CORRELATION BETWEEN STOCKS & REAL ESTATE = 25%
THEN 50% R.E. / STOCKS MIXTURE WOULD PROVIDE:
EXPECTED RETURN = 12.5%;
STD.DEV. = 10.0%
________________________________________________________
BORROW $1.0
INVEST $2.0 IN RISKY MIXED-ASSET PORTFOLIO (v = 2).
(2.0)12.5% + (-1.0)5% =
20%
RISK WOULD BE:

(2.0)10.0% + (-1.0)0% =
20% <
22.5%
_______________________________________________________
LEND (INVEST IN BONDS) $0.33
INVEST $0.67 IN RISKY MIXED-ASSET PORTFOLIO (v = 0.67).
(0.67)12.5% + (0.33)5% =
10%
RISK WOULD BE:

(0.67)10.0% + (0.33)0% = 6.7% < 7.5%
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50
THE GRAPH BELOW SHOWS THE EFFECT DIVERSIFICATION IN

THE RISKY PORTFOLIO HAS ON THE RISK/RETURN POSSIBILITY
FRONTIER.
25%
Effect of diversification: Stocks, R.E., & Riskless Asset
Exptd Return
20%
15%
10%
5%
0%
0%
5%
10%
15%
20%
25%
Risk in overall w ealth portfolio
THE FRONTIER IS STILL A STRAIGHT LINE ANCHORED ON THE

RISKFREE RATE, BUT THE LINE NOW HAS A GREATER SLOPE,
PROVIDING MORE RETURN FOR THE SAME AMOUNT OF RISK,
ALLOWING LESS RISK FOR THE SAME EXPECTED RETURN.
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51
THE "OPTIMAL" RISKY ASSET PORTFOLIO WITH A RISKLESS ASSET

(aka "TWO-FUND THEOREM")
E[Return]
rj
rP
ri
P
i
rf
Risk(Std.Dev.of Portf)
CURVED LINE IS FRONTIER OBTAINABLE INVESTING ONLY IN RISKY

ASSETS
STRAIGHT LINE PASSING THRU rf AND PARABOLA IS OBTAINABLE BY
MIXING RISKLESS ASSET (LONG OR SHORT) WITH RISKY ASSETS.
YOU WANT HIGHEST STRAIGHT LINE POSSIBLE (NO MATTER WHO YOU
ARE!).
OPTIMAL STRAIGHT LINE IS THUS THE ONE PASSING THRU POINT "P".
IT IS THE STRAIGHT LINE ANCHORED IN rf WITH THE MAXIMUM POSSIBLE
SLOPE.
THUS, THE STRAIGHT LINE PASSING THROUGH P IS THE EFFICIENT
FRONTIER. THE FRONTIER TOUCHES (AND INCLUDES) THE CURVED LINE
AT ONLY ONE POINT: THE POINT "P".
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52
THUS, THE "2-FUND THEOREM" TELLS US THAT THERE IS A

SINGLE PARTICULAR COMBINATION OF RISKY ASSETS (THE
PORTFOLIO P) WHICH IS "OPTIMAL" NO MATTER WHAT THE
INVESTOR'S RISK PREFERENCES OR TARGET RETURN.
E[Return]
rj
rP
ri
P
i
rf
Risk(Std.Dev.of Portf)
THUS,
ALL EFFIC. PORTFS ARE COMBINATIONS OF JUST 2 FUNDS:
RISKLESS FUND (long or short position) + RISKY FUND "P" (long position).
HENCE THE NAME: "2-FUND THEOREM".

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53
21.3.2
HOW DO WE KNOW WHICH COMBINATION OF RISKY ASSETS IS
THE OPTIMAL ALL-RISKY PORTFOLIO P?
IT IS THE ONE THAT MAXIMIZES THE SLOPE OF THE STRAIGHT
LINE FROM THE RISKFREE RETURN THROUGH P. THE SLOPE
OF THIS LINE IS GIVEN BY THE RATIO:
Portfolio Sharpe Ratio = (rp - rf) / sP
MAXIMIZING THE SHARPE RATIO FINDS THE OPTIMAL RISKY
ASSET COMBINATION. THE SHARPE RATIO IS ALSO A GOOD
INTUITIVE MEASURE OF RISK-ADJUSTED RETURN FOR THE
INVESTORS WEALTH, AS IT GIVES THE RISK PREMIUM PER UNIT
OF RISK (MEASURED BY ST.DEV).
THUS, IF WE ASSUME THE EXISTENCE OF A RISKLESS ASSET,
WE CAN USE THE 2-FUND THEOREM TO FIND THE OPTIMAL
RISKY ASSET MIXTURE AS THAT PORTFOLIO WHICH HAS THE
HIGHEST "SHARPE RATIO".
Reserved.
54
BACK TO PREVIOUS 2-ASSET NUMERICAL EXAMPLE...

USING OUR PREVIOUS EXAMPLE NUMBERS, THE OPTIMAL COMBINATION
OF REAL ESTATE & STOCKS CAN BE FOUND BY EXAMINING THE SHARPE
RATIO FOR EACH COMBINATION . . .
RE share
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
rP
rp-rf
15.0%
14.5%
14.0%
13.5%
13.0%
12.5%
12.0%
11.5%
11.0%
10.5%
10.0%
10.0%
9.5%
9.0%
8.5%
8.0%
7.5%
7.0%
6.5%
6.0%
5.5%
5.0%
sP
15.0%
13.8%
12.6%
11.6%
10.7%
10.0%
9.5%
9.2%
9.2%
9.5%
10.0%
Sharpe
Ratio
66.7%
68.9%
71.2%
73.2%
74.6%
75.0%
73.8%
70.5%
65.1%
58.0%
50.0%
OF THE 11 MIXTURES CONSIDERED ABOVE, THE 50% REAL ESTATE

WOULD BE BEST BECAUSE IT HAS THE HIGHEST SHARPE MEASURE.
BUT SUPPOSE YOU ARE NOT SATISFIED WITH THE 12.5% Er THAT WILL
GIVE YOU FOR YOUR OVERALL WEALTH?
OR YOU DONT WANT TO SUBJECT YOUR OVERALL WEALTH TO 10%
VOLATILITY?...
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55
THEN YOU CAN INVEST PROPORTIONATELY 50% IN REAL ESTATE AND

50% IN STOCKS,
AND THEN ACHIEVE A GREATER RETURN THAN 12.5% BY BORROWING
(LEVERAGE, v > 1),
OR YOU CAN INCUR LESS THAN 10.0% RISK BY LENDING (INVESTING IN
GOVT BONDS, v<1)
(BUT YOU CANT DO BOTH. THE FREE LUNCH OF PORTFOLIO THEORY ONLY GETS
YOU SO FAR, THAT IS, TO THE EFFICIENT FRONTIER, BUT ON THAT FRONTIER THERE
WILL BE A RISK/RETURN TRADEOFF. THAT TRADEOFF WILL BE DETERMINED BY THE
MARKET)

Reserved.
56
Example of Difference Between Markowitz and Sharpe

Optimal Portfolios
Exh.21-12:

Reserved.
57
2-FUND THEOREM SUMMARY:

1) THE 2-FUND THEOREM ALLOWS AN ALTERNATIVE,
INTUITIVELY APPEALING DEFINITION OF THE OPTIMAL
RISKY PORTFOLIO: THE ONE WITH THE MAXIMUM
SHARPE RATIO.
2) THIS CAN HELP AVOID "SILLY" OPTIMAL PORTFOLIOS
THAT PUT TOO LITTLE WEIGHT IN HIGH-RETURN
ASSETS JUST BECAUSE THE INVESTOR HAS A
CONSERVATIVE TARGET RETURN. (OR TOO LITTLE
WEIGHT IN LOW-RETURN ASSETS JUST BECAUSE THE
INVESTOR HAS AN AGGRESSIVE TARGET.)
3) IT ALSO PROVIDES A GOOD FRAMEWORK FOR
ACCOMMODATING THE POSSIBLE USE OF LEVERAGE,
OR OF RISKLESS INVESTING (BY HOLDING BONDS TO
MATURITY), BY THE INVESTOR.
Reserved.
58
21.4: Some Broader Considerations in Portfolio Allocation

Commercial real estate (CRE) is a large share of total
investable wealth ($Trillions)
Houses; 20
Bonds; 38
CRE; 9
Stocks; 15
12% of total investable wealth

Reserved.
59
Why do U.S. Pension Funds Invest So Little in Real Estate?...

$15 Trillion U.S. Pension Fund Assets
Defined
Benefit (DB):
$6.6 trillion
Defined
Contribution (DC):
$8.6 trillion
& growing.
DB plans often fall short of their DC plans need new vehicles for
stated CRE targets
making CRE investments.
60
Exhibit 21-13: Top Risk Factors in Real Estate as

Cited by U.S. Pension Funds
Source:DharandGoetzmann2004surveyofU.S.pensionfundsforPREA.
Reserved.
61
Problems with investing in private real estate

Illiquidity
Large transactions costs
Large investment management costs
Large capital outlay requirements
Difficulty measuring asset values
Infrequent return measurement
Impossibility of short positions

Reserved.
62
Why do U.S. Pension Funds Invest So Little in Real

Estate?...
Uncertainty is a bigger impediment than

risk (uncertainty is inability to know or
quantify the risks)
PFs feel disadvantaged relative to
information and ability to execute, relative
to local entrepreneurial players
Investment mgrs take large fees and may
have conflicts of interest
Reserved.
63
Chapter 21 Summary: MPT & Real Estate . . .

The classical theory suggests a fairly robust, substantial role for the real estate
asset class in the optimal portfolio (typically 25%-40% without any additional
assumptions), either w or w/out riskless asset.
This role tends to be greater for more conservative portfolios, less for very
aggressive portfolios.
Role is based primarily on diversification benefits of real estate, somewhat
sensitive to R.E. correlation w stocks & bonds.
Optimal real estate share roughly matches actual real estate proportion of all
investable assets in the economy.
Optimal real estate share in theory is substantially greater than actual pension
fund allocations to real estate in U.S.
Optimal R.E. share can be reduced by adding assumptions and extensions to
the classical model:
Correct for appraisal-smoothing, private mkt lag, variable liquidity (as in HW3).
Extra transaction costs, illiquidity penalties;
Long-term horizon risk & returns;
Net Asset-Liability portfolio framework;
Investor constrained to over-invest in owner-occupied house as investment.
But even with such extensions, optimal R.E. share often substantially exceeds
existing P.F. allocations to R.E. (approx. 3% on avg.*)
Reserved.
64
Appendix 21A
I. REVIEW OF STATISTICS ABOUT PERIODIC TOTAL RETURNS:
(Note: these are all time-series statistics: measured across time, not across assets within a
single point in time.)
"1st Moment" Across Time (measures central tendency):
MEAN, used to measure:
Expected Performance ("ex ante", usually arithmetic mean: used in portf ana.)
Achieved Performance ("ex post", usually geometric mean)

"2nd Moments" Across Time (measure characteristics of the deviation around the central
tendancy). They include
1) "STANDARD DEVIATION" (aka "volatility"), which measures:
Square root of variance of returns across time.
"Total Risk" (of exposure to asset if investor not diversified)

2) "COVARIANCE", which measures "Co-Movement", aka:
"Systematic Risk" (component of total risk which cannot be "diversified away")
Covariance with investors portfolio measures asset contribution to portfolio total

risk.
3) "CROSS-CORRELATION" (just correlation for short). Based on contemporaneous
covariance between two assets or asset classes. Measures how two assets "move together":
important for Portfolio Analysis.

4) "AUTOCORRELATION" (or serial correlation: Correlation with itself across time), which
reflects the nature of the "Informational Efficiency" in the Asset Market; e.g.:
Zero
"Efficient" Market (prices quickly reflect full information; returns
lack predictability) Like securities markets
(approximately).
Positive
"Sluggish" (inertia, inefficient) Market (prices only gradually
incorporate new info.) Like private real estate
markets.
Negative
"Noisy" Mkt (excessive s.r. volatility, price "overreactions")
65
Like securities markets (to some extent).
"Picture" of 1st and 2nd Moments . . .
L.R. trend of asset value:

1st moment only of return
Actual asset value:

1 & 2nd moments of
return
st
First Moment is "Trend. Second Moment is "Deviation" around trend.

Food for Thought Question:
IF THE TWO LINES ABOVE WERE TWO DIFFERENT ASSETS, WHICH
WOULD YOU PREFER TO INVEST IN, OTHER THINGS BEING EQUAL? . . .
Asset A?, or Asset B? 2014 OnCourse Learning. All Rights
Reserved.
66
Line B:
G-Mean/Yr = 8.9%
A-Mean/Yr = 8.9%
Ann. Vol. = 0%
Line A:
G-Mean/Yr = 8.9%
A-Mean/Yr = 12.2%
Ann. Vol. = 18%

Reserved.
67
Line B:
G-Mean/Yr = 6.4%
A-Mean/Yr = 6.4%
Ann. Vol. = 0%
Line A:
G-Mean/Yr = 6.4%
A-Mean/Yr = 9.7%
Ann. Vol. = 18%

Reserved.
68
Historical statistics, annual periodic total returns:

Stocks, Bonds, Real Estate, Annual-frequency statistics 1975-2009 (trough-to-trough)
S&P500
LTG Bonds
Private
Real Estate
Mean (arith)
13.2%
9.6%
10.0%
Std.Deviation
17.5%
12.5%
10.9%
100%
3%
12%
100%
-4%
1st Moments
Correlations:
S&P500
LTG Bonds
Priv. Real Estate
2nd Moments
100%
PORTFOLIO THEORY IS A WAY TO CONSIDER BOTH THE 1ST &

2ND MOMENTS (& INTEGRATE THE TWO) IN INVESTMENT
ANALYSIS.

Reserved.
69

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Chapter 21

MACRO-LEVEL REAL ESTATE

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21.2 Basic Mean-Variance Portfolio Theory

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21.2.1. Investor Preferences & Dominant Portfolios

Utility preference surface for return & risk:

THE CONTOUR LINES (UTILITY ISOQUANTS) STEEPLY RISING IN RETURN

21.2.1. Investor Preferences & Dominant Portfolios

Utility preference surface for return & risk:

THE CONTOUR LINES (UTILITY ISOQUANTS) SHALLOWER:

BOTH INVESTORS WOULD AGREE THEY PREFER POINTS TO THE

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Making the analysis more formal & rigorous

e.g., If Asset A has E[rA]=5% and Asset B has E[rB]=10%, then a

THE 2ND FACT:

< wsi + (1-w)sj , where: s=StDev, C=correl

e.g., If Asset A has StdDev[rA]=5% and Asset B has

Heres a picture of these two mathematical facts:

e.g., where P is { (1/2)A & (1/2)B }

SUPPOSE STOCKS HAVE:

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Portf Exptd Return

Portf Exptd Return

Portf Risk (STD)

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21.2.2 Effect of diversification (Exhs.21-4&5)

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21.2.2 Effect of diversification (Exhs.21-4&5)

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1970-2010 Sm/Lg Stk correl = +71%

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1970-2010 Bd/RE correl = 0%

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KEY POINT THAT YOU CAN ALREADY SEE WITHOUT FANCY

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21.2.3 Perceived Role of Real Estate in the Mixed-Asset Portfolio

Everything went down

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Much recent bemoaning the lack of diversification between real estate

Much recent bemoaning the lack of diversification between real estate

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Much recent bemoaning the lack of diversification between real estate

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Much recent bemoaning the lack of diversification between real estate

Big Bear Events:

Fat tails (non-normality) can be represented by big bear events (asset

Much recent bemoaning the lack of diversification between real estate

Much recent bemoaning the lack of diversification between real estate

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Trough-to-Trough history is fair and conservative 35-year

21.2.4 STEP 1: FINDING THE EFFICIENT FRONTIER

INVESTING IN ANY ONE OF THE THREE ASSET CLASSES WITHOUT

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INVESTING IN ANY ONE OF THE THREE ASSET CLASSES WITHOUT

IN A RISK/RETURN CHART LIKE THIS, ONE WANTS TO BE ABLE TO GET AS

ALLOWING PAIRWISE COMBINATIONS (AS WITH OUR PREVIOUS STOCKS

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FINALLY, IF WE ALLOW UNLIMITED DIVERSIFICATION AMONG ALL THREE

Exh.21-7c: THIS IS THE EFFICIENT FRONTIER (IN THIS CASE OF

EFFICIENT FRONTIER CONSISTS OF ALL ASSET

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MATHEMATICALLY, THIS IS A "CONSTRAINED

Remember: Milton Friedman told Harry