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THE ALLOCATION FOR REAL ESTATE WITHIN THE MIXED ASSET PORTFOLIO

Investigating the time-varying nature of the relationships amongst assets, sustainable asset allocation and the tendency of asset correlation to rise during periods of economic uncertainty, which questions diversification benefits.

MAY 2013 BSc. INVESTMENT AND FINANCE IN PROPERTY

SPIN NUMBER: U0657 STUDENT NUMBER: 18023815

SCHOOL OF REAL ESTATE AND PLANNING

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Acknowledgements Several people have contributed to the completion of this study in many ways and I am very grateful for their help. I first of all thank God, without Him none of this would have been possible. I am grateful to Charles Ward and Adeyinka Adewale for their guidance and support. I also thank Peter Byrne, Tumellano Sebehela and Gianluca Marcato for helpful comments, assistance and advice.

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TABLE OF CONTENTS ABSTRACT 1 - INTRODUCTION 2 - LITERATURE REVIEW 2.1 - UNDERSTANDING REAL ESTATE AS AN ASSET CLASS 2.2 - REAL ESTATE AS A DIVERSIFIER 2.3 - TIME-VARYING CORRELATION AND ASSET ALLOCATION 2.4 - EFFECTS OF VALUATION SMOOTHING 2.5 - NON-NORMALITY OF REAL ESTATE RETURNS 2.6 - THE TENETS OF MODERN PORTFOLIO THEORY 3 - METHODOLOGY 4 - EMPIRICAL RESULTS 4.1 - REGRESSION ANALYSIS 4.2 - MEAN VARIANCE ANALYSIS AND OPTIMISATION 5 - CONCLUSION 6 - BIBLIOGRAPHY 7 – APPENDICES 7.1 - APPENDIX 1 – REGRESSION RESULTS 7.2 - APPENDIX 2 – CORRELATION M ATRICES 7.3 – APPENDIX 3 – DATASET 7.4 – APPENDIX 4 – DE-SMOOTHING 4 6 8 8 9 10 12 13 14 15 18 18 20 23 25 28 28 30 31 32

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TABLE OF FIGURES FIGURE 1: ASSET RISK AND RETURN COMPARISON (1987-2011 QUARTERLY) FIGURE 2: ASSET KURTOSIS AND SKEWNESS COMPARISON (1987-2011 QUARTERLY) FIGURE 3: OBSERVATIONS FIGURE 4: REGRESSION (1) FIGURE 5: REGRESSION (2) FIGURE 6: REGRESSION (3) FIGURE 7: REGRESSION (4) FIGURE 8: REGRESSION (5) FIGURE 9: ASSET ALLOCATION CALCULATED YEARLY (TABULAR FORM) FIGURE 10: ASSET ALLOCATIONS CALCULATED YEARLY (VISUAL IMPRESSION) FIGURE 11: ASSET ALLOCATION CALCULATED EVERY 5 YEARS (TABULAR FORM) FIGURE 12: ALLOCATIONS EVERY 5 YEARS (VISUAL IMPRESSION) FIGURE 13: ASSET ALLOCATIONS EVERY 3 YEARS (TABULAR FORM) FIGURE 14: ALLOCATIONS EVERY 3 YEARS (VISUAL IMPRESSION) FIGURE 15: BEAR AND BULL ALLOCATIONS FIGURE 16: REGRESSION RESULTS FIGURE 17: CORRELATION MATRICES FIGURE 18: DATA SET FIGURE 19: DE-SMOOTHING METHODS 9 13 16 18 18 19 19 19 20 21 21 22 22 22 23 28 30 31 32

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Abstract The inclusion of private real estate in a mixed asset portfolio has been advocated mainly for its diversification ability besides several other known benefits. However, the strength of this position in times of economic uncertainty remains questionable as discovered through recent studies, which have argued that the correlations between real estate and other asset classes could rise during periods of economic upturn and downturn. The implication is that diversification benefits of private real estate diminish when they are required the most, weakening the argument supporting its inclusion as an integral component of a mixed asset portfolio. This study aims at investigating the time varying relationship between real estate and other asset classes during periods of economic uncertainty using regression, as well as the stability or sustainability of asset allocation. Negative total construction production periods, a market volatility series and market portfolio bear periods were employed as three economic variables for this investigation. Data was obtained for each variable from reliable secondary sources and analysed with E-views and Excel. Findings suggest that in periods of economic volatility, the beta value of property returns increases. This implies that correlations with other assets increase thereby nullifying the advantages of including real estate in the mixed asset portfolio. It was also discovered that asset allocation is unsustainable especially in varied economic conditions. Furthermore, key statistical limitations in the study were identified and their implications critically discussed. It concludes by establishing that the relationship between real estate and other asset classes varies with market volatility, an indication that the perception of real estate as a diversifier should be reconsidered.

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1 - Introduction The recent global financial crisis changed the perception of private real estate to its investors on the role it plays in a mixed asset portfolio. Central to this shift are two key issues namely: the diversification benefits of including real estate in a mixed asset portfolio and the sustainability of asset allocation in varied economic periods. It is well known that an optimal mixed asset portfolio is not just a product of the assets included, but also relationships amongst these assets, in addition to their respective allocations and diversification qualities. The inclusion of real estate in a mixed asset portfolio has therefore been strongly supported mainly for its diversification ability aside inflation hedging and other return enhancement characteristics (CBRE, 2012; Baum, 2002; Lee, 2003a). However, recent studies have shown that correlations between real estate and other asset classes rose during the global financial crisis and also generally during periods of economic downturn (Lizieri, 2013; IPF 2012a and Lee, 2003c). This rise casts doubt on the diversification ability and benefits of real estate, which are understood to lie predominantly in its low relative relationship compared to other asset classes. The mean variance analysis (MVA), a key analytical tool for optimal portfolio allocation uses the correlation between direct real estate and other asset classes in determining the benefits of including real estate in the mixed asset portfolio (Lee, 2003c). Therefore, monitoring the correlations becomes a critical factor. For real estate, the basis of the low correlations has been attributed to the fact that property returns are determined by yields and rents, which are only loosely connected with the equity and bond market. Other factors including the assets illiquid nature, its low trading volumes as well as valuation smoothing make the correlations of real estate and other asset classes appear lower than they actually are. Whilst property prices are appraisal/valuation based, the pricing mechanism for other assets like gilts and equities are transaction/market based. It has been strongly argued that this has led to the volatility of real estate to be considerably understated. Therefore when optimisers consider the benefits of real estate in a mixed asset portfolio, the observed features of appraisal based returns give real estate much higher allocations (Lee & Stevenson, 2004), far greater than the proportions held by investors in mixed asset portfolios. Much of the existing research on real estate investment characteristics sits within a conventional or traditional finance framework drawing on Modern Portfolio Theory (MPT) and Capital Asset Pricing Model (CAPM) (IPF, 2012a). In line with MPT, approaches to asset allocation are typically established on basic of low average correlation with other asset classes, which are assumed to be constant over time (CBRE, 2012; IPF, 2012d). This assumption implies that asset returns follow a Multi-Variate Normal (MVN) distribution (IPF, 2012a). A MVN distribution implies that the relationships (correlations) between asset return distributions are the same in normal, extreme bullish and bear markets. However, existing literature suggests that correlations may vary through time, as correlations tend to be higher in periods of increased uncertainty and during bear markets. The correlation is a crucial portfolio parameter for MVA, as it measures the strength of association between assets to generate optimum allocations. Yet, there is some evidence to suggest that the correlation is not a constant fixed distribution but a parameter that is itself dependent on economic 6

and market conditions. This can have serious portfolio implications with regards to asset allocation, especially during periods of economic downturn. It may indicate that MPT’s tenets concerning portfolio diversification can fail when they are needed most. Thus, Lee (2003a) explains that a single portfolio allocation strategy may not be optimal because assets show different returns over varied economic and financial environments. Moreover, the assumption of MVN distributions with real estate returns also implies symmetry in the return distribution patterns. Fabozzi (2009) suggests that the assumption of normal distributions in asset classes should be rejected. He adds that variance is an inappropriate measure of risk when return distributions are not symmetric. Likewise Young, Lee and Devaney (2006) explain that it is unsafe assuming normality in property returns. Traditional framework such as MPT are essentially one-period models that fail to take into account varied market conditions and can produce results that are at odds with investor expectations. This would imply that investors using MPT approaches for asset allocation might not get the diversification benefits when they require it most. Therefore IPF (2012a) advise that asset allocation models need to incorporate higher order terms of dependence to minimize portfolio risk as the Markowitz Framework intended. Moreover, the time varying nature of correlation can result in portfolio risk-return characteristics being at odds with the investors risk attitude; such errors would need to be corrected through expensive portfolio rebalancing activity. In the single index model of asset returns, beta is identified as the visible component of the systematic risk of any traded asset. So in this research project, regression is used to investigate how beta changes with respect to different economic variables. Furthermore, asset allocations in global minimum variance portfolios will be studied using the mean variance analysis to investigate the stability of asset allocation during changing economic and financial environments. Proving that weights or allocation percentages proposed for property in any one period are unlikely to be found in another, similar to Byrne and Lee (1995) findings. The question then is how investors and fund managers are to adjus t. As Lee and Stevenson’s (2006) findings advise, the benefits of the inclusion of real estate tend to increase as the investment horizon is extended. It implies that real estate should be considered as a strategic asset class within the mixed asset portfolio. Whilst Lee (2002) suggests that fund managers may be given the discretion to deviate from strategic asset allocation weights to take advantage of tactical consideration, he cites Harrison (1992) who argues that such deviations are usually set within tight limits. However, even if limits were considerably loose, the characteristics of direct real estate as an asset class make it difficult and onerous for institutional investors, fund managers and investors to frequently rebalance these mixed asset portfolios. This is mainly due to the illiquid nature of the asset. On the other hand, according to Byrne & Lee (2003), the ex-post deviation is fairly irrelevant for the larger institutional investors (who are more likely to hold larger allocations to property), as they are more concerned with the terminal wealth of the portfolio along with the standard deviation of this

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terminal wealth. That is to say, as Lee and Stevenson (2004) found, real estate should be considered as a strategic asset class. It indicates that less consideration should be given to the in-period portfolio volatility that the asymmetric nature of real estate returns may cause and more focus placed on the terminal wealth and terminal wealth standard deviation (TWSD). Besides Byrne & Lee (2003) show that the inclusion of real estate in the mixed asset portfolio offers improvements in terminal wealth and TWSD. The next section reviews the extensive research and literature on the allocation of real estate within the mixed asset portfolio, including other relevant themes. Next, the methods used to investigate the study are stated followed by the empirical results. The final section discusses the findings and reviews the implications for the real estate in the mixed asset portfolio during periods of economic uncertainty, whilst suggesting possible routes for further study.

2 - Literature Review 2.1 - Understanding Real Estate as an Asset Class Fabozzi (2009) and Gruber (1997) agree that an asset class can be defined in the terms of their shared investment attributes, fundamental economic similarities along with other characteristics, which differentiate them from assets that are not part of the class. Fabozzi (2009) suggests that defining an asset class this way means that the correlation of returns between different asset classes will be low. The former statement is accurate in that, economic fundamentals together with the indivisible nature and low trading volumes of real estate can distinguish its returns from other mixed asset portfolio counterparts like equities that are conversely divisible and experience high trading volumes. However, Fabozzi (2009) falls short on this suggestion as he fails to recognise the time varying nature of correlations between assets especially during periods of economic uncertainty, like the recent global financial crisis. Lizieri (2013) explains that as a consequence of the global financial crisis the perception of real estate as a risk diversifier in mixed asset portfolios with doubt being cast on the risk management role of real estate within the mixed asset portfolio. Although the ability of real estate to act as a portfolio diversifier has been questioned, it is important to note that within and out of the mixed asset portfolio context, real estate does offer other benefits. One of which is that it serves as a hedge against inflation. It also has high and stable income growth and presents the possibility of capital gain. CBRE (2012) note that this is an important part of the investment decision, especially for investors following asset-liability matching strategies. Some of the shortcomings of the asset class include its high transaction cost, large lot size, indivisibility and quite importantly the illiquid nature of the asset (Knight, Lizieri and Satchell, 2005; Lee, 2005; Lee & Stevenson 2005; Lee & Stevenson, 2004, Macgregor & Nanthakumaran, 1992).

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2.2 - Real Estate as a Diversifier For over 20 years researchers have been recommending that investors diversify their mixed asset portfolios by adding direct real estate (Lee, 2003c). This recommendation fundamentally originates from the combination of apparently strong risk-adjusted returns and low observed correlation between real estate and other asset classes. In line with MPT, assets that are less than perfectly correlated with other assets in a mixed asset portfolio reduce the portfolio variance, as the different return patterns partially offsets others with the effect of smoothing the whole portfolios volatility. Whilst Sebehela (2012) suggests that most empirical studies of developed markets illustrate that alternative investments such as real estate are for minimising risks of diversified portfolios as opposed to increasing returns. Lee and Stevenson (2006), deduce from their study that within a shorter investment horizon (5 year holding period) the return enhancement benefits of direct real estate is on average greater than its risk reduction/diversification benefits. The generally improved risk adjusted returns that emerge from the inclusion of direct real estate in the mixed asset portfolio are a result of the position that real estate adopts on the efficient frontier. Its low position (low variance, low returns) on the frontier allows it to produce better risk-adjusted returns than other assets. As Figure 1 below shows, direct real estate has the ability to produce similar returns with substantially lower risks. Figure 1: Asset Risk and Return Comparison (1987-2011 Quarterly) Asset IPD All Property Index Return Equities - (FTAS) UK Gilts - 5 to 15years Return 2.209% 2.527% 2.133% Risk 3.340% 7.906% 2.461%

Source: IPD UK Monthly Market Digest January 2011

Furthermore, in comparison with other assets that use a transactional-based system, the pricing mechanism for the assets in the direct real estate market is valuation/appraisal based. Lee (2005) explains that the appraisal process induces ‘sluggishness’ in to the volatility of real estate returns. This ‘sluggishness’ seldom allows for rapid sharp rises or falls in real estate asset prices, which are often seen in other transaction based mixed asset portfolio counterparts like equities and gilts. Others argue that this sluggishness may be an inherent characteristic of the real estate asset class. As this study will show, the diversification benefits that direct real estate offers are often ‘absent’ because of the inaccurate depiction of diversification that time-varying correlations produce. It has significant implications for asset allocation. The theme of the ‘absent’ diversification and risk reduction benefits of real estate in mixed asset portfolios has been to topic of many published studies (see Lizieri, 2013; IPF, 2012a; IPF, 2012d; Knight, Lizieri and Satchell, 2005; Lee, 2003a for reviews). They have argued that the correlation of property with other assets vary markedly during periods of economic downturn, reducing the stabilising effect of a diversified portfolio. Meaning that diversification often fails and investors may not get the benefits they require when they are needed 9

the most. Once more, the rationale behind real estate as a diversifier in a mixed asset portfolio stems from its low correlation with other asset classes. This makes the asset a premier choice in asset allocation and optimisers models. However, as the literature has shown, and will show as we go on, the fundamentals behind real estate’s augmentation as a diversifier in a mixed asset portfolio can be questioned. Since the diversification benefits are often absent conceivably due to time-varying correlations, which has implications for sustainable asset allocation. 2.3 - Time-Varying Correlation and Asset Allocation Reilly and Brown (2005) rightly explain that one of the major advances in the investment field over the past few decades has been the recognition that the creation of an optimal investment portfolio does not simply involve combining numerous individual assets that have suitable risk-return characteristics. As MPT emerged, the focus shifted from the individual assets to the portfolio composition as a whole as well as the relationships between assets within the portfolio. In lieu of fighting capital markets, these strategies aim to intelligently ride with them (Gibson, 1990). Likewise Macgregor & Nanthakumaran (1992) make accurate assertions in acknowledging that a portfolios composition is not only based on the risk and return characteristics of individual assets but also on the degree of association between the asset classes’ return.

The degree of association, which is measured by the historical correlation between assets value one of the elements that MPT approaches adopt to obtain various asset allocations. It is assumed that this correlation is constant over time, however empirical data suggests that these correlations are timevarying. IPF (2012a) thoroughly expound on this by noting that the seminal works of Markowitz (1952), Sharpe (1964) and Elton and Gruber (1977) demonstrate that the concept of dependence between asset returns is fundamental to asset allocation and portfolio construction. It is noted that as the number of assets in the portfolio rises, the total risk of the portfolio converges to the average covariance between the assets rather than the risk characteristics of any individual assets (Elton and Gruber, 1977). As previously described, the correlation is not a constant fixed distribution but a parameter that is itself dependent on economic and market conditions. Employing this figure will produce inaccurate depictions of the true time varying nature of correlation relationships. Lizieri (2013) finds that volatility in correlations indicate that basic single-period covariance approaches to risk diversification may be misleading. Such an approach implies that the periods where diversification benefits may exist due to the inclusion of real estate and other particular asset combinations vary over time, due to structural changes in the correlation patterns.

Bearing in mind the fact that creation of optimal allocations for various asset classes is the focal point of the investment process; Gibson (1990) explains that the choice of asset categories and their respective weights in a portfolio will have a large impact on future performance. A study by Meesmore (1995) found that the impact of the inclusion of real estate in a mixed asset portfolio depended on the allocation percentage assigned to real estate, as well as the asset class replaced within the portfolio. Likewise, Lee (2003b) finds that real estate can increase the compound returns of a portfolio above 10

an existing portfolio consisting of other assets. However, the impact would be dependent on the percentage allocation of real estate and the assets replaced. The preceding evidence validates the fundamental role that asset allocation plays in the investment process. Since the historical correlation between assets is the element that MPT approaches adopt in obtaining various asset allocations, the accuracy and stability of the figure is crucial. Without this accuracy and stability, asset allocations may end up being contradictory to investor risk-return appetites. Consequently necessitating constant and expensive portfolio rebalancing activity, which can be exacerbated if the correlation patterns are volatile. Leading to a conclusion that over time a single portfolio allocation strategy may not be optimal. With regards to real estate, its illiquid nature, large lot size, indivisibility, low trading volumes along with its high transactional costs make constant portfolio rebalancing an especially impractical task. What are then the implications for fund managers and investors holding real estate in their mixed asset portfolios? Byrne and Lee (2003) and Lee (2003b) argue that long term institutional investors who may have longer holding periods, should be less concerned about the in-period volatility of their mixed asset portfolios. Rather more attention be paid to maximising the terminal wealth and compound returns as well as reducing the terminal wealth standard deviation (TWSD). This was reinforced by findings, which demonstrated that the inclusion of real estate in the mixed asset portfolio appeared to offer improvements in terminal wealth and compound returns together with a reduction to the TWSD. This seems like a plausible suggestion as Lee and Stevenson (2006) argue that real estate should be considered as a strategic asset class seeing as the benefits of its inclusion tend to increase as the investment horizon is extended. However, albeit the terminal wealth and the ability of institutional investors to meet their financial obligations and finance the liabilities is key, it can be argued correctly that no less concern should be shown towards the in-period volatility. This is because; irrespective of reporting period (annually, bi-annually or quarterly) these institutional investors and fund managers are required to report their progress and performance to the investors. Regardless of a fund manager’s ability to deliver superior compound returns, if there is constant in-period volatility or inperiod underperformance in the mixed asset portfolios, it brings unease due to consistently imbalanced investor risk-return preferences, loss of goodwill and possibly scepticism in the achievability of financial obligations. Therefore, due to the crucial role correlations play in optimisers and because these correlations are time varying especially during periods of economic downturn, it can be suggested that sustainable asset allocation may not be achievable particularly vis-à-vis the real estate asset class. Seeing as correlation is not a constant fixed distribution but a parameter that is itself dependent on economic and market conditions real estate allocations in a mixed asset portfolio will vary during different economic conditions. Gibson (1990) notes the simultaneous shift of attention from return enhancement in favour of risk reduction, this is even more pertinent after the recent global financial crisis. This denotes that risk averse investor appetites will be harder to maintain if volatile correlations 11

continue producing inaccurate representations of the increased diversification and risk-adjusted benefits of the inclusion of real estate in mixed asset portfolios. Particularly if these diversification benefits will not be delivered when they are required the most. 2.4 - Effects of Valuation Smoothing As opposed to the market based pricing system of equities and gilts, the valuation based pricing system for property has been widely criticised. It is commonly agreed that the awareness and understanding of risk in performance measurement in real estate is still relatively limited. Part of the reason for this is the focus on traditional teaching methods of valuation, which fail to wholly place property in a capital market context (Reilly and Brown, 2005). This means that property returns are slow to react to the changes in expectations about the economic environment (Macgregor & Nanthakumaran, 1992). It is maintained that this has led to lower correlations of real estate with other asset classes, also causing the volatility of real estate to be considerably understated (Lee, 2005; Lee and Stevenson, 2004). Since optimisers allocate assets within a portfolio in accordance with the relationship between assets, in a standard mixed asset portfolio with equities, gilts and real estate, real estate usually has unrealistically high allocations, even after data has been de-smoothed and risk premia added for illiquidity (IPF, 2012a; Lee, 2005; Byrne and Lee, 1995). Much higher than what is owned by institutional investors. Moreover, Sanders (1998) found that after adjusting NCREIF index for appraisal bias private real estate still received 10%-40% allocations within the mixed asset portfolio, which is in line with other studies (Hoesli et al. 2004). In the face of uncertainty and as a result of thin transaction volumes, IPF (2012a) explain that valuation procedures involve valuers using their own historical appraisals and weighted averages of contemporaneous information sets. They explain that any series that is effectively a ‘moving average’ will understate the volatility of any underlying asset market, consequently overstating the risk-adjusted returns. Revealing that the benefits of real estate in mixed asset portfolios may be exaggerated. On the other hand, though Macgregor & Nanthakumaran (1992) acknowledge that the volatility of property is understated, they suggest that the complexity of processes such as demand, supply, planning constraints along with other events that may not be directly triggered by the economy but are specific to the property market, may occur. They explain that such occurrences may cause adjustments to income and capitalisation rates, possibly demonstrating that low relative correlations between property and other assets may be an inherent characteristic of the property market. Rather than data or valuation related influences. Alternatively, the accuracy of transaction/market based figures against that of direct property valuations can be questioned. As it can be correctly argued that sharp rises and falls in transaction/market-based approaches may not represent a change in fundamentals but rather changes in inflation and other factors. Therefore transaction/market-based indices must not always be thought of as superior to valuation-based systems.

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2.5 - Non-Normality of Real Estate Returns MPT approaches assume that return distributions for assets (in this case real estate) are MVN. Implying that the relationships between assets are idem in normal, extreme bullish and bear markets. This forms the basis of Markowitz – mean-variance portfolio selection models. Fabozzi (2009) states that empirical studies of financial markets together with theoretical arguments suggest that MVN distributions of returns in general should be rejected. Adding that real world distributions have ‘fatter’ and ‘heavier’ tails than normal distributions. Likewise, Young, Lee and Devaney (2006) find that it is unsafe to assume normality of property returns, since normality was rejected in UK annual IPD data. Explaining further that lack of normality in real estate data is mainly due to the thinness and lack of liquidity of the market. In Young, Lee and Devaney (2006) case, the implication is that the distribution of returns may be far from normal and in some cases be nearer to a very long-tailed distribution – with the tails so far extended that it may not even be useful to calculate parameters such as variance or skew. In this extreme position, the whole approach to portfolio formation based on a two parameter-distribution falls down. An alternative explanation can be found in the regime shift approach where the returns may indeed be normally distributed but the distribution itself shifts between two or more regimes. These regimes may be provoked by changes in the external environment or they may be almost randomly generated. In the former case, it is perfectly possible to explain why the returns of each asset may appear to have long tails yet at the same time be capable of allowing single period portfolio analysis based on mean and variance. The linkage is the ability of the investor to forecast in which regime the model is currently operating. In the multiregime approach it is perfectly possible to observe shifting correlations specifically higher correlations during periods of financial stress and lower correlations during periods of financial calm (IPF, 2012a). The assumption of multi-variate normality is rejected in the real estate returns data used for this study. As Figure 2 shows below, considerably higher negative skewness and high positive kurtosis was observed in real estate asset returns than any of the other asset classes analysed. Figure 2: Asset Kurtosis and Skewness Comparison (1987-2011 Quarterly) All Property Kurtosis Skewness 4.332 -1.464 Equities - All Share 1.359 -0.946 Gilts - 5 to 15 years -0.270 -0.327

Source: IPD UK Monthly Market Digest January 2011

As Lizieri and Ward (2001) found, irrespective of region or property type, normality is rejected in most cases. The main reason for the inappropriate fit is the leptokurtic nature of real estate returns. IPF (2012a) logically explains that if the probability of 2 assets both having positive returns is not equal to the probability of those assets both having negative or low returns, then the standard symmetric dependence implied in the variance covariance matrix and standard portfolio model inadequately describes the true dependence between those assets.

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Observations of increased asset return dependence similar to those seen in the recent global financial crisis was also made during the 1997-1998 Russian and Asian financial panics and subsequent to the US terrorist attacks in 2001 (Lizieri, 2013; Gordon, 2009). The fact that the dependence of real estate returns and the returns of other assets varies with market trends, and the tendency of increased dependence in the face of economic uncertainty is referred to as asymmetric dependence (IPF, 2012a). The dependence between returns is asymmetric when higher correlations are observed during the periods of economic downturn, whilst lower correlations are observed during periods of economic upturn. Asymmetric dependence can be seen as a statistical confirmation of the time varying nature of financial asset class returns. It demonstrates the greater tendency of relationship between assets to rise during periods of economic downturn. Showing once again that diversification benefits may be absent when they are required the most. IPF (2012a) advise that asset allocation models need to incorporate higher order terms of dependence to minimize portfolio risk as the Markowitz Framework intended. 2.6 - The Tenets of Modern Portfolio Theory The tenets of MPT form the basis of the perpetually evolving investment field. Michaud (1998) states that mean variance efficiency is the classic paradigm of modern finance for efficient allocation of capital amongst risky assets. These tenets are tied with certain assumptions about economic behaviour and market structure that are disputed in broader investment spectrum, and can be problematic within real estate markets. This is because whilst MPT is a one period model, private real estate assets are long period assets. IPF (2012a) explain that MPT and CAPM rest on precarious assumptions, and in reality not all assets are marketable, investors face capital constraints, investor risk attitudes do not follow a quadratic utility function and there are barriers to investment. Additionally, more specific to real estate, costs vary by asset class and within this asset class transaction and acquisition costs are considerably higher. More importantly these theories wrongly assume that dependence between assets can be fully characterised by the variance covariance matrix, which includes the covariance (correlation) between returns. What’s more, Michaud (1998) and Macgregor & Nanthakumaran (1992) agree that mean variance optimisers magnify the impact of estimation error by overusing statistically estimated information, meaning that eventual optimised portfolios are error maximised and often lack practical investment value. The quadratic utility function simply signifies that as long as there is sufficient return compensation, investors are willing to take on more risk. However, this is at odds with actual investor behaviour because over a certain risk level, regardless of the appeal of return, investors will be reluctant. Lizieri (2013) meticulously states that adopting a single time period, mean-variance optimisation approach will not capture the changing risk return characteristics of real estate. Explaining further that betas and asset correlations are time varying, along with the influence of other assets on the volatility of real estate. One might argue that the fundamentals that MPT lie on are crumbled.

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Michaud (1998) clarifies that the practical limitations of MPT and MVA are not a reflection of conceptual flaws of Markowitz, but flaws in implementation. Suggesting that these implementation errors reflect lack of understanding of the fundamental statistical nature of MVA. Moreover, Young, Lee and Devaney (2006) note that there is no way to measure co-dependence among property risk functions with statistical tools currently available. Regardless, these flaws, which include the assumption of normality, still have strong negative asset allocation implications for investors. Fabozzi (2009) explains that if return distributions were symmetric then variance and standard deviation would be good measures of risk but they are not. He explains that returns are better described as following a lognormal distribution. Consequently, alternative risk measures have been recommended. Byrne and Lee (1997) propose a Mean Absolute Deviation optimisation, which is sensitive to departures from normality but still produces optimal portfolio compositions similar to MVA (Young, Lee and Devaney, 2006). Hamelink and Hoesli (2004) use a maximum drawdown function, Stevenson (2001) argues for the use of Bayes-Stein estimators, whilst others have suggested semi-variance measures. Though researchers have advocated the use of these measures, IPF (2012a) note that much of the literature has not considered whether the benefits of diversification will be uniform across the distribution, in that extreme events will have been accounted for. On the other hand, Macgregor & Nanthakumaran (1992) identify through MPT that use of historical data is of limited use in decision-making. Consequently, a recommendation is made for econometric techniques to forecast income under differing economic scenarios and a discounted cash flow valuation model that would produce proper expectation based analysis of return and risk. However, this is subject to complete comprehension of economic conditions under which asset returns are similar and those whose returns are dissimilar. This would require an understanding of drivers of various asset classes’ returns. Nonetheless, we seek to question whether MPT’s focus on correlation, mean and standard deviation can sufficiently characterise the time varying nature of the degree of association between real estate returns and the returns of other asset classes. Along with sufficiently characterising property risk, in the ability of real estate allocations in mixed asset portfolios to remain the same in varied economic conditions under the tenets of MPT. Consistently maintaining investor risk appetites and consequently avoiding costly portfolio rebalancing activity, which is more apparent with the private real estate asset class.

3 - Methodology The time-series data employed for the study was United Kingdom private commercial real estate returns, ranging from April 1988 to January 2011 (92 quarterly observations). The United Kingdom forms a valuable case study due to the availability of time series of reasonably robust monthly investment return data from the Investment Property Databank monthly index. Moreover, the United Kingdom enjoys consistent capital investment into the London property market, because of its reputation as a safe haven for overseas investors.

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As smoothing is likely to be a problem at index level and is more acute in monthly property indices than in annual or quarterly indices, the study was conducted in quarterly periods. Nevertheless we carry out a de-smoothing exercise to investigate whether the problem exists in a sufficiently strong form to affect the findings. The aggregation of properties into an index causes variation in returns to be understated. In using appraisal based real estate data, researchers have typically attempted to remove the impact of a valuation updating process, initially identified by, inter alia Quan and Quigley (1989), using some form of filtering process: for reviews see, for example, Fisher et al. (2003), Geltner et al. (2003), Marcato & Key (2007) or Lizieri et al. (2012). Adopting the Fischer, Geltner and Webb (1994) de-smoothing methods, after running regressions significance was discovered in the 1 and 2
st nd

period lags. These were the 2 periods used in the

equation that derived the de-smoothed return series. The assumption that the standard deviation of de-smoothed private real estate returns is approximately half the volailty of equity returns, which in this case is the FT All share Index, was also adopted from the Fischer et al. (1994) methods. However, it should be noted that no de-smoothing process is perfect and the choice of method may bias the results.
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The empirical analysis conducted for this study is divided into two parts: 1. Using a regression analysis, this study will evaluate the time varying nature of the correlation between real estate and other asset class returns during the identified varied economic periods. To identify the periods of economic downturn, quarterly time-series data (1988-2011) for Gross Domestic Product in the United Kingdom and Production of Total Construction in United Kingdom was collected from the St. Louis Federal Reserve Bank (Federal Reserve Economic Data). Technically the indicator of a recession or a period of financial stress is two consecutive quarters of negative economic growth as measured by a country's Gross Domestic Product. For the purposes of this study, this indicator was also applied to production of total construction figures. The table below shows after employing this method, only 4 recessions or periods of financial stress were identified from the GDP, whilst 13 periods of financial stress were identified from the total construction time-series data. Figure 3: Observations Production of Total Construction in the United Kingdom 13

Gross Domestic Product in the United Kingdom Total Amount of 2 consecutive quarters of negative growth

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1

See Appendix 4 for more details

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Subsequently a new time series was then derived from identified as bear periods. In this new data series the quarters where bear periods were not identified were recorded as a ‘0’ and the identified bear periods were recorded as ‘1’ multiplied by the retur n of the quarter where the period of economic downturn was found. However, 4 & 13 periods did not form a sufficient argument for the study so periods of negative growth, in every quarter in the Production of total Construction in the United Kingdom was used as the Bear Indicator. We identify this as the ‘Bear’ variable. The Gross Domestic Product for the United Kingdom was overlooked due to its lack of numerous negative growth periods. Similar to the ‘Bear’ time series variable the ‘Portfolio Dummy V ariable’ was obtained by identifying periods of negative growth within the mixed asset portfolio. Finally, for the main proposition that asset relationships rise in periods of volatility, whether upwards or downwards, a final time series which took account for this volatility was derived. We identify this as the ‘Market Portfolio Volatility’ variable. Finally, the IPD All Property Returns, which is the dependent variable, will be regressed against the explanatory variables, which are the market portfolio return, market portfolio returns t-1, the bear time series and the time-series indicating volatility in the asset market place. Afterwards, the beta (regression coefficient), t-statistic and the Adjusted R-Squared will be evaluated to identify sensitivity and significance during the varied periods; this sensitivity will also indicate greater levels of association, which includes correlation. The equations for the regression exercise are shown below: RP = α + β R M + ε RP = α + β0 RM + β1 RM(t-1) RP = α + β0 RM + β1 RMV + ε RP = α + β0 RM + β1 Bear + ε RP = α + β0 RM + β1 RMD + ε Where: RP refers to the Property Returns. RM refers to the Market Portfolio Returns. RM(t-1) refers to the Market Portfolio Returns lagged by 1 period. RMV refers to the Market Portfolio (Volatility) period. Bear refers to the derived Bear Market time-series. (1) (2) (3) (4) (5)

17

RMD refers to the dummy variable created from negative periods within the Mixed Asset Portfolio returns. 2. The global minimum variance of mixed asset portfolios will be obtained yearly, as well as on a 3year and a 5-year basis by adopting the mean-variance approach. The portfolios will comprise of IPD All Property Index Return, FTSE All Share Equity returns and UK 10-15 year gilts. The various asset allocations will then be compared to investigate the sustainability and variation of asset allocations in the mixed economic conditions. With a specific comparison on allocations during selected identified periods of economic upturn and downturn. This will help evaluate long term asset allocation and whether if weights or allocation percentages proposed for real estate in any one period are likely to be found in another.

4 - Empirical Results 4.1 - Regression Analysis Subsequent to the literature review the expectations for the results are that in periods of economic upturn and downturn, the parameter estimate for beta would be expected to be higher – Implying that the correlation had increased. One does not need a formal test to see that it is simply implausible to maintain the idea that the beta could be constant over the whole period. The study therefore moves on to investigating whether there are any economic explanations of why the beta is shifting over time. Nevertheless we report for the sake of consistency the regression (1) in the table below. That is the simple beta of property with respect to the market portfolio. Figure 4: Regression (1): - RP = α + βRM + ε β Regression (1) 0.696 Adj-R 0.24
2 2

T-Statistic 5.46

This result reveals that over the whole period, the beta of property was 0.69. Plainly the beta is significantly different from 0 and the regression explains over 20% of the total variation of the property returns. Figure 5: Regression (2):- RP = α + β0 RM + β1 RM(t-1) + ε β0 Regression (2) 0.703 β1 -0.029 Adj-R .233
2

T-Statistic -0.225902

2

See Appendix 1 for full regression results.

18

This result reveals that over the whole period, the beta of property averaged around 0.7. Plainly the beta is significantly different from 0 and the regression explains about 23 % of the total variation of the property returns. But there is no evidence that there is any delay in reacting to the market index. This is not surprising given that the property returns have been de-smoothed. Figure 6: Regression (3):- RP = α + β0 RM + β1 RMV + ε β0 Regression (3) 0.502020 β1 Adj-R
2

T-Statistic 0.776501

0.213059 0.23

This result reveals that over the whole period, the beta of property averaged around 0.72. Plainly the beta is significantly different from 0 and the regression explains about 23% of the total variation of the property returns. This is the only regression equation that resulted in a beta that was higher (3%) than that of the simple beta of property returns with respect to the market portfolio. Moreover, though insignificant this equation produced the highest positive t-statistic. Figure 7: Regression (4):- RP = α + β0 RM + β1 Bear + ε β0 Regression (4) 0.720900 β1 Adj-R
2

T-Statistic -0.223295

-0.046114 0.233

This result reveals that over the whole period, the beta of property averaged around 0.67. Plainly the beta is significantly different from 0 and the regression explains about 23% of the total variation of the property returns. The result from the beta for the Bear indicator simply signifies that the production of total construction in the United Kingdom is insignificant in the context of the IPD All property returns. Figure 8: Regression (5) - RP = α + β0 RM + β1 RMD + ε β0 Regression (5) 0.825543 β1 Adj-R
2

T-Statistic -0.908795

-0.440704 .24

This result reveals that over the whole period, the beta of property averaged around 0.4. Plainly the beta is significantly different from 0 and the regression explains about 24 % of the total variation of the property returns. The t-statistic and beta value demonstrate insignificance. Due to the increase in beta in volatile periods there is a demonstration that the results are to an extent in line with and consistent to previous expectations. Ensuing from the standard errors in the regression results we are unable to explicitly state statistical significance, also because of the low t19

statistic and probability figures. However, if a longer time series was available with more economicwide and property specific cycles, it can be suggested that greater statistical significance can be attained. 4.2 - Mean Variance Analysis and Optimisation
3

The tables below show the global minimum variance of mixed asset portfolios (comprising of IPD Property Index, FTSE All Share Equity returns and UK 10-15 year gilts) through the periods in the data set available. They were derived by adopting the mean-variance approach. The results generally upholds the case that real estate allocations found in one period are unlikely to be found in another as Byrne and Lee (1995) found, especially during periods of economic downturn. The visual impressions below show that there is wide variation in the allocation of real estate in the mixed asset portfolio. The standard deviations of the allocations were typically 18% over the different time periods analysed. Though this standard deviation was to an extent parallel with gilts, the nature of real estate as an asset class makes the transaction and trade of them on a regular basis relatively difficult. Whilst gilts and equities can be sold in a matter of minutes it is important to consider that it may take from 6 months and upwards to dispose of a property asset. Meaning that slight changes in optimal allocations will be very costly. Furthermore, when comparing allocations in bull and bear markets the standard deviations of private real estate reached up to 23%. The average allocation of real estate within the mixed asset portfolio in the bear period with the allocation to real estate in the bull had considerable differences at 18% and 50% respectively. As explained earlier this is due to the fact the optimiser process is ideally a one period model. Whilst this can be applied to other assets with ease, it may cause problems with real estate because its inherent characteristics make it a very long period asset. Figure 9 below shows the asset allocations within the mixed asset portfolios if the optimisation process was done yearly. Figure 11 shows the allocations if the optimisation process was done every 5 years and Figure 13 shows the allocations when allocations on a 3 year basis. See Figure 15 for a comparison of allocations in bear and bull periods of the market. Figure 9: Asset Allocation calculated yearly (Tabular Form)
Date Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 All Property Returns 0.00% 0.00% 25.33% 23.01% 20.37% 37.53% 38.73% 38.37% Equities - All Share 0.68% 0.00% 0.00% 0.00% 0.93% 0.00% 0.00% 0.00% Gilts - 5 to 15 years 99.32% 100.00% 74.67% 76.99% 78.71% 62.47% 61.27% 61.63%

3

Gilts consistently remained an asset with considerably large allocations because the portfolios constructed were constructed

at their global minimum variance.

20

Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

38.87% 40.49% 47.28% 47.84% 49.85% 50.18% 50.46% 49.83% 48.70% 48.68% 38.23% 33.91% 24.43% 20.75%

0.00% 0.96% 1.97% 2.18% 2.73% 3.25% 3.33% 2.96% 2.73% 3.82% 4.77% 5.55% 7.50% 8.88%

61.13% 58.55% 50.75% 49.98% 47.41% 46.57% 46.22% 47.20% 48.58% 47.50% 57.01% 60.55% 68.06% 70.37%

Variance Standard Deviation

0.02 0.15

0.00 0.03

0.03 0.16

Figure 10: Asset Allocations calculated yearly (Visual Impression)
120.00% 100.00% 80.00% 60.00% 40.00% 20.00% 0.00%

Desmoothed All Property Returns

Equities - All Share

Gilts - 5 to 15 yrs

Source: IPD UK Monthly Market Digest January 2011

Figure 11: Asset Allocation calculated every 5 years (Tabular form)
Date Jan-91 Jan-96 Jan-01 Jan-06 Jan-11 All Property Returns 0.00% 38.73% 47.84% 48.70% 20.75% Equities - All Share 0.00% 0.00% 2.18% 2.73% 8.88% Gilts - 5 to 15 years 100.00% 61.27% 49.98% 48.58% 70.37%

Variance Standard Deviation

0.04 0.21

0.00 0.04

0.04 0.21

21

Figure 12: Allocations Every 5 years (Visual Impression)
120.00%

100.00%

80.00%

60.00%

40.00%

20.00%

0.00%

Desmoothed All Property Returns

Equities - All Share

Gilts - 5 to 15 yrs

Source: IPD UK Monthly Market Digest January 2011

Figure 13: Asset Allocations every 3 years (Tabular form)
Date Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 All Property Returns 0.00% 23.01% 38.73% 40.49% 49.85% 49.83% 38.23% 20.75% Equities - All Share 0.68% 0.00% 0.00% 0.96% 2.73% 2.96% 4.77% 8.88% Gilts - 5 to 15 years 99.32% 76.99% 61.27% 58.55% 47.41% 47.20% 57.01% 70.37%

Variance Standard Deviation

0.029 0.17

0.00 0.03

0.03 0.17

Figure 14: Allocations every 3 years (Visual Impression)
120.00% 100.00% 80.00% 60.00% 40.00% 20.00% 0.00%

All Property Returns

Equities - All Share

Gilts - 5 to 15 yrs

Source: IPD UK Monthly Market Digest January 2011

22

Figure 15: Bear and Bull Allocations
Bear Period Allocations Date Jul-90 Jul-08 Average Allocation Bull Period Allocations Date Apr-04 Oct-05 Average Allocation

All Property Returns 0% 35.14% 17.57%

Equities - All Share 0% 4.22% 2.11%

Gilts - 5 to 15 years 100% 60.64% 80.32%

All Property Returns 50.23% 48.70% 49.47%

Equities - All Share 3.31% 2.72% 3.02%

Gilts - 5 to 15 years 46.46% 48.58% 47.52%

Standard Deviation between Bear and Bull Standard Deviation

0.23

0.01

0.23

5 - Conclusion As it was discussed earlier, the inclusion of real estate in a mixed asset portfolio has been advocated mainly for its diversification ability aside inflation hedging and other return enhancement characteristics (CBRE, 2012; Baum, 2002; Lee, 2003a). The basis of these diversification benefits originate from the low degree of association between real estate and other asset classes, however due to the time-varying or asymmetric nature of real estate returns these benefit have often been absent. In this paper the time-varying nature of private real estate asset returns were explored, using a regression exercise where the analysis of the beta (sensitivity) and statistical significance would demonstrate the outcomes. Though the increase in beta in volatile periods demonstrated that the results are to an extent in line with and consistent towards previous expectations, we are unable to explicitly state statistical significance, because of the low t-statistic, Adjusted R-squared and probability figures. However, if a longer time series was available with more economic-wide and property specific cycles, it can be suggested that greater statistical significance can be attained. Yet, the results do validate the suggestion that the correlation or association is not a constant fixed distribution but rather a parameter that is itself is dependent on economic and market conditions. Pointing to the ideology that the diversification benefits of real estate, which are arguably their most valuable attribute, are often absent when they are required the most, which are effectively during the periods of economic downturn. Moreover, the comparison of asset allocations over varied periods upheld the case for unsustainable asset allocation. The average allocation of real estate within the mixed asset portfolio in the bear period with the allocation to real estate in the bull had considerable differences at 18% and 50% respectively. Consequently fund managers and real estate investors are left to deal with consistently imbalanced investor risk-return preferences and the high-priced ordeal of rebalancing the real estate in the mixed asset portfolio. However, as Byrne and Lee (2003) and Lee (2003b) argue, long term institutional investors who may have longer holding periods should be less concerned about the inperiod volatility of their mixed asset portfolios. Besides, Lee and Stevenson (2006) explain that real estate should be considered as a strategic asset class. Nevertheless, this comes with its inconveniences. 23

This is not to say that diversification benefits are non-existent. The impression seems to be that due to the increase in correlations in volatile market periods the diversification benefits seem to diminish or fall. The argument for diversification being a significant characteristic and a strong benefit of private real estate is still a robust one. As it seems that it’s illiquidity, tangible nature and valuation-based market pricing system as well as other dynamics consistently keep it at a contrast with the other asset classes. Nevertheless, due to the increased degree of association between real estate and other assets it is an indication that the perception of real estate as a diversifier should be reconsidered. Further investigation can be undertaken to discover whether or not the asset correlation of equities, gilts and other mixed asset portfolio counterparts rise in accordance or equally with themselves and real estate. Meaning that the effect of the rising correlation and possibly diminishing diversification benefits between asset classes effectively cancel each other out in the face of economic uncertainty or during volatile market conditions.

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6 - Bibliography Byrne, P.J. and Lee, S. (1995), Is There a Place for Property in the Multi-Asset Portfolio, Journal of Property Finance, 6(3), p.60-83. Byrne, P.J. and Lee, S. (2003), The Impact of Real Estate on the Terminal Wealth of The UK Mixed Asset Portfolio, Department of Real Estate and Planning, Working paper 05/03. Cho, H., Kawaguchi, Y. and Shilling, J. (2003), Unsmoothing Commercial Property Returns: A Revision to Fisher-Geltner-Webb’s Unsmoothing Methodology, Journal of Real Estate Finance and Ecoonmics, 27, pp393-405 Elton, E.J. and Gruber, M.J. (1977), Risk Reduction and Portfolio Size: An Analytical Solution , Journal of Business, 50, 415-437. Elton, J., Gruber, M., Brown, S., and Goetzmann, W. (2007), Modern Portfolio Theory and Investment Analysis, United States of America: John Wiley and Sons Inc. Fabozzi, F. (2009) Institutional Investment Management, New Jersey: John Wiley and Sons Inc. Fisher, J.D., Geltner, D. M. and Webb R.B. (1994), Value Indices of Commercial Real Estate: A Comparison of Index Construction Methods. Journal of Real Estate Finance and Economics 9: 137-164. Gibson, R. (1990), Asset Allocation: Balancing Financial Risk, New Jersey: McGraw Hill. Greer, R. (1997), What is an Asset Class, Anyway? The Journal of Portfolio Management, Vol. 23, No. 2: pp. 86-91. Haddock, M. (2012), Time to Overweight Real Estate – The Case for Property in 2012. Hakkio, C. and Keeton, K., (2009), Financial Stress: What Is It, How Can It Be Measured, and Why Does It Matter? Publications of Federal Reserve Bank of Kansas City. Hamelink, F., MacGregor, B., Nanthakumaran, N. and Orr, A. (2002) A Comparison Of UK Equity And Property Duration, Journal of Property Research, 19 (1). pp. 61-80. Hishamuddin, Mohd A., (2004), Modern Portfolio Theory: Is There Any Opportunity for Real Estate Portfolio? Available at: http://www.scribd.com/doc/85138105/14-26 [Date Retrieved:

December 2012]. Hoesli, M. and Hamelink, F. (1996), Diversification of Swiss portfolios with real estate, Results based on a hedonic index, Journal of Property Valuation and Investment, Vol. 14 Iss: 5, pp.59 – 75. Hoesli, M., Lekander, J. and Witkiewicz, W. (2004), International Evidence on Real Estate as a Portfolio Diversifier, Journal of Real Estate Research, 26, 161-206.

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IPF (April, 2012), Real Estate’s Role in the Mixed Asset Portfolio: A Re-examination, Working Paper 1. Real Estate Returns and Other Asset Classes: A Review of Literature. IPF (May, 2012), Real Estate’s Role in the Mixed Asset Portfolio: A Re-examination, Working Paper 2 Private Commercial Real Estate Returns and the Valuation Process. IPF (May, 2012), Real Estate’s Role in the Mixed Asset Portfolio: A Re-examination, Working Paper 3 Time Varying Influences on Real Estate Returns. IPF (May, 2012), Real Estate’s Role in the Mixed Asset Portfolio: A Re-examination, Working Paper 4 Real Estate Returns and Financial Assets in Extreme Markets. Knight, J., Lizieri, C. and Satchell, S. (2005), Diversification When It Hurts? The Joint Distributions of Real Estate and Equity Markets, Journal of Property Research, 22(4), 309-323. Lee S, Byrne, P.J. (1997), Diversification by Sector, Region or Function? A Mean Absolute Deviation Optimisation, Journal of Property Valuation and Investment, 16(1), p.38-56. Lee, S. (1998), The Case for Property in the Long Run: A Cointegration Test, Working Papers in Land Management and Development 06/98 University of Reading. Lee, S. (2002), Is There A Case for Property All The Time, Working Papers in Real Estate & Planning 09/02 University of Reading. Lee, S. (2003), Impact of Real Estate on the Mixed Asset Portfolio in Periods of Financial Stress , Working Papers in Real Estate & Planning 04/03 University of Reading. Lee, S. (2003), When Does Direct Real Estate Improve Portfolio Performance, Working Papers in Real Estate & Planning 17/03 University of Reading. Lee, S. (2005), The Return Due to Diversification to the US Mixed Asset Portfolio , The Journal of Real Estate Portfolio Management, 11(1), p.19-28. Lee, S. and Stevenson, S. (2005), The Consistency of Private and Public Real Estate within Mixed Asset Portfolios, Working Papers in Real Estate & Planning 08/05 University of Reading. Lee, S. and Stevenson, S. (2006), Real Estate in the Mixed Asset Portfolio: The question of Consistency, Journal of Property Investment and Finance, 24(2), p.123-135. Levy, H. and Sarnat, M. (1983) Portfolio and Investment Selection: Theory and Practice , New York: Prentice-Hall. Lizieri, C. (2013), After the Fall: Real Estate in the Mixed Asset Portfolio in the Aftermath of the Global Financial Crisis.

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Lizieri, C. and Ward, C. (2001), The distribution of commercial real estate returns , In: Knight, J. and Satchell, S. (eds.) Return Distributions in Finance. Quantitative Finance. ButterworthHeinemann, Oxford, pp. 47-74. Macgregor, B. and Nanthakumaran, N. (1992), The Allocation in The Multi Asset Portfolio: The Evidence and Theory Reconsidered, Journal of Property Research, 9:1, 5-32. Markowitz, H. (1952), Portfolio Selection, Journal of Finance, 7 (1): 77-91. Messmore, T. (1995), Variance Drain, The Journal of Portfolio Management, Summer, 104-10. Michaud, R. (1998), Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, Harvard Business School Press. Osei-Nkansah, D. and Kifleyesus, S. (2003), Institutional Investor Behaviour In Allocating Real Estate In The Mixed – Asset Portfolio, Department of Infrastructure, Division of Building and Real Estate Economics Royal Institute of Technology, Stockholm-Sweden, Master of Science Thesis No. 202. Reilly, F. and Brown, K. (2005), Investment Analysis and Portfolio Management, United States of America: Cengage South-Western (8 Edition). Rudd, A. and Rosenberg B. (1979), Realistic Portfolio Optimisation, In Portfolio Theory, 25 Years After, edited by Elton, E. and Gruber, M., Amsterdam: North Holland. Sanders, J. (1998), An Updated Look at Asset Allocation: Private and Public Real Estate in a MixedAsset Class Portfolio, Institute for Fiduciary Education, 9/98. Sirmans, C. and Worzala, W. (2002), International Direct Real Estate Investment: A Review of the Literature, Urban Studies, Vol. 40 (5-6): 1081-1114. Stevenson, S. (2001), Bayes-Stein Estimators & International Real Estate Asset Allocation, Journal of Real Estate Research, 2001, 21:1, 89-103. Sebehela, T. (2012), South Africa REITs and Alternative Investments, International Journal of Finance and Management, 2012, Vol 2, Issue 1. Young, M., Lee, S. and Devaney, S. (2006), Non-Normal Real Estate Return Distributions by Property Type in the UK, Journal of Property Research, 23 (2): 109-133.
th

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7 – Appendices 7.1 - Appendix 1 – Regression Results Figure 16: Regression Results
Dependent Variable: PROPRET Method: Least Squares Date: 05/08/13 Time: 22:23 Sample: 1988Q2 2011Q1 Included observations: 92 Variable C PORTFOLIORETURNS R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient 0.004434 0.696385 0.249173 0.240830 0.035949 0.116307 176.4301 29.86775 0.000000 Std. Error 0.004665 0.127423 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat t-Statistic 0.950593 5.465139 Prob. 0.3444 0.0000 0.019611 0.041258 -3.791958 -3.737137 -3.769832 1.714987

Dependent Variable: PROPRET Method: Least Squares Date: 05/08/13 Time: 22:27 Sample: 1988Q2 2011Q1 Included observations: 92 Variable C PORTFOLIORETURNS PORTFOLIOLAG R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient 0.004932 0.702654 -0.029529 0.249603 0.232740 0.036140 0.116240 176.4565 14.80193 0.000003 Std. Error 0.005182 0.131072 0.130718 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat t-Statistic 0.951829 5.360832 -0.225902 Prob. 0.3438 0.0000 0.8218 0.019611 0.041258 -3.770792 -3.688560 -3.737603 1.733736

Dependent Variable: PROPRET Method: Least Squares Date: 05/08/13 Time: 22:28 Sample: 1988Q2 2011Q1 Included observations: 92 Variable C PORTFOLIORETURNS PORTFOLIOVOLATILITYDUMMY R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient 0.006512 0.502020 0.213059 0.254225 0.237466 0.036028 0.115524 176.7407 15.16947 0.000002 Std. Error 0.005387 0.281003 0.274384 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat t-Statistic 1.208926 1.786528 0.776501 Prob. 0.2299 0.0774 0.4395 0.019611 0.041258 -3.776971 -3.694739 -3.743782 1.716692

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Dependent Variable: PROPRET Method: Least Squares Date: 05/08/13 Time: 22:30 Sample: 1988Q2 2011Q1 Included observations: 92 Variable C PORTFOLIORETURNS BEAR R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient 0.004350 0.720900 -0.046114 0.249593 0.232730 0.036140 0.116242 176.4558 14.80115 0.000003 Std. Error 0.004705 0.168712 0.206517 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat t-Statistic 0.924624 4.272972 -0.223295 Prob. 0.3577 0.0000 0.8238 0.019611 0.041258 -3.770779 -3.688547 -3.737590 1.716559

Dependent Variable: PROPRET Method: Least Squares Date: 05/08/13 Time: 22:27 Sample: 1988Q2 2011Q1 Included observations: 92 Variable C PORTFOLIORETURNS PORTFOLIODUMMY R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient -0.000379 0.825543 -0.440704 0.256076 0.239359 0.035983 0.115237 176.8550 15.31794 0.000002 Std. Error 0.007061 0.190962 0.484932 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat t-Statistic -0.053696 4.323082 -0.908795 Prob. 0.9573 0.0000 0.3659 0.019611 0.041258 -3.779456 -3.697224 -3.746267 1.699170

29

7.2 - Appendix 2 – Correlation Matrices Figure 17: Correlation Matrices

30

7.3 – Appendix 3 – Dataset Figure 18: Data Set

31

7.4 – Appendix 4 – De-smoothing Figure 19: De-Smoothing Methods

Adopting the Fischer, Geltner and Webb (1994) de-smoothing methods: rst= (rst -1.68 * rst-1 + 0.81 * rst-1 )/ 0.63
Standard Deviation of Equities Standard Deviation of Residuals from Regression W 0 = (2 x 2.5%)/7.9% W 0 = 0.63 7.90% 2.50%

32