Download Nova Southeastern University H. Wayne Huizenga School of

1
Nova Southeastern University
H. Wayne Huizenga School
of Business & Entrepreneurship
Assignment for Course: REE 5894: Capital Markets
Submitted to: Jorge San Miguel
Submitted by: Kyle Thompson
N01089259
[email protected]
321-848-3224
Date of Submission: 11/17/2015
Title of Assignment: Modern Portfolio Theory Applied to Real Estate
CERTIFICATION OF AUTHORSHIP: I certify that I am the author of this paper and that any
assistance
I received in its preparation is fully acknowledged and disclosed in the paper. I have also cited
any
sources from which I used data, ideas or words, either quoted directly or paraphrased. I also
certify that
this paper was prepared by me specifically for this course.
Student's Signature: ______Kyle Thompson _____________
*****************************************************************
Instructor's Grade on Assignment:
Instructor's Comments:
2
One of the most widely used tools to diversify a portfolio is modern portfolio theory, which was
introduced by Harry Markowitz in a 1952 article resulting in a noble prize for his work.
(Markowitz, 1991) This mathematical equation looks at the expected returns, risks, and the
amount of each asset class, and finds the ideal combination of investments to maximize the
portfolio return or minimize the portfolio risk. (Matuszak, 2010) The topic of discussion for this
paper will be the use of MPT in diversifying a portfolio, consisting of commercial real estate or
income producing properties. Income producing property varies from traditional investment
strategies because of the large amount of capital that is needed to invest and outside factors that
affect returns and risks.
MPT needs three pieces of information in order to conduct an analysis: the expected return from
an investment, normally shown as the Internal Rate of Revenue (IRR) or in investment property
as the Capitalization Rate of a property. Capitalization Rate or Cap rates looks at the value of the
property and its relation to how much that property produces in annual income. The volatility of
each asset refers to the standard deviation or beta, making the assumption that a set percentage of
results are within a range of the mean. (Hines, 2009) An efficient real estate portfolio aims at
diversifying assets so that the correlation coefficient between assets in the portfolio is as close to
zero as possible. A correlation of zero would show no relationship between the assets in the
portfolio, which would minimize the volatility. (Young, 1993. Pg. 2-13) This can be
accomplished by investing into properties located in different cities or investing in multiple
properties in the four asset classes of real estate investments: Office, Retail, Industrial, and
Multi-family. (Young, 1993. Pg. 2-13)
Criticism of MPT in the past has come from assumptions that Markowitz set forth. Assuming
that investors are risk adverse, suggesting that if an investor is given the choice of two assets
with the same expected return then the investor would prefer the less risky asset. (Hines, 2009)
Additional criticism comes from MPTs use of standard deviation to define risk. This implies that
there is an equal chance of a return being worse than expected and vice versa. This can result in
investments appearing riskier than they may really be and vice versa. (Hines, 2009)
The use of MPT in real estate portfolios did not gain popularity until about the 1990s. Susan
Hudson-Wilson, the author of the article, addressed two factors for this in the article; the lack of
sufficient data for investment “analysis” and the fact that investors did not see real estate
properties as being unique from one to another. (Hudson-Wilson, 2000) It wasn’t until around
the 1980s that NCREIF created property index, but it was nowhere near enough information to
find returns and risk on commercial properties. This data did not include individual property
performances, but instead clustered properties on their type and location. (Young, 1993. Pg. 213)
The second factor discussed by the author was how real estate properties are unique from one
another, meaning that individual properties are independent of one another. There are a number
of limitations that will affect the use of MPT in real estate: Market cycles, tenant vacancies,
property type and geographical location, liquidation period, economic influences, and potential
structural damages. These factors will be discussed further due to their impact on the ability for a
property to generate income.
Market conditions will play a vital role in the performance of an income producing property. The
graph to the left, and the graph to the right both illustrate the economic cycles that markets
(cities) and asset classes will go through.
3
(Doug, 2013)
(Troen, 2015)
For MPT to be applied to real estate assets, similar property types must be exhibiting similar
returns. The same can be stated for property types in a centralized market. (Young, 1993. Pg. 213) Notice, in both graphs, how the location of a property and the type of property will both
influence the expected performance. Although market conditions are key to a property’s
performance, they tend to influence real estate property slowly over time. The biggest amount of
influence on a property comes from “property-specific circumstances.” (Young, 1993. Pg. 2-13)
These factors are such things as vacancies, rent averages, type of leases, number of tenants, and
operating expenses will have major impacts on the performance of a property. (Young, 1993. Pg.
2-13)
Now that we have discussed the constraints of investing in commercial property, we can begin to
construct an investment strategy to form an efficient portfolio. There are a few ways that one can
diversify a real estate portfolio. The first is investing in pension, mutual, or trust funds like
investing in REITs or NCREIFs. Here, investors will invest funds into the company and that
company will in invest in a number of different real estate assets. (Fabozzi, 1996) This allows
investors the opportunity to invest in real estate, without having to invest as much of their own
capital. (Fabozzi, 1996) This investment strategy gives financial professionals the funds to invest
in range of income producing properties. Further discussion on diversifying a real estate portfolio
will focus on how these companies would go about constructing an efficient portfolio or the
formation of an individual investor’s portfolio (who has the available capital to invest in
commercial properties).
4
The independence of individual properties from one another gives investors the opportunity of
“clustering” similar property types or properties in similar locations together. (Hudson-Wilson,
2000) This clustering technique
allows for illustration of portfolio
diversification without having to
use mathematical models. This
approach is known as naïve
diversification or using their own
instinctive common sense.
(Definition of "Naive
diversification") The graph to the
right illustrates the expected
returns and volatility of the
subclasses of real estate in the Los
Angeles County area. (Young,
1993. Pg. 2-13) Although these
commercial properties are located
in the same area, they appear to be
independent when comparing
expected returns and risk.
(Young, 1993. Pg. 2-13)
Although this method shows a number of moderate returns over time, is it the most efficient
portfolio for an investor? Markowitz developed a model to determine the “optimal” portfolio,
called a market efficient frontier. (Matuszak, 2010) The frontier is “the highest attainable returns
associated with each level of risk.” (Hudson-Wilson, 2000) The frontier will be shown as a
positive or negative curved line, where the different points represent different portfolio scenarios.
(Matuszak, 2010) Shown in the below graph, the line can be constructed through excel using a
program called Solver. (Matuszak, 2010) This program will require further research, however we
will address the necessary steps that must be taken to construct the frontier line. One would need
the expected returns of each asset, then a covariance table can be formed. This table illustrates
the how the volatility of all the assets move together, or the overall standard deviation of the
portfolio. (Matuszak, 2010) Next one must take the square root of the sum of the portfolio’s
variance. (Matuszak, 2010) One may then begin to construct the portfolio, using Sharpe’s ratio,
by dividing the average return of the portfolio by the overall standard deviation. (Matuszak,
2010) Once this is done the Solver program will be run a number of times, each time increasing
the expected return. The results of the program should resemble the table below. One will look to
see when the slope (Sharpe’s ratio) begins to level off or decrease as the average returns
increase. (Matuszak, 2010)
5
(Matuszak, 2010)
The last step is simply graphing the frontier line, which is done by plotting each separate
portfolio’s return and standard deviation on the graph. (Matuszak, 2010) The below graph is an
efficient frontier example, an investor would look for the portfolio that falls on the part of the
line with the greatest slope. (Matuszak, 2010) The optimal portfolio would be a return of 0.75%
and a volatility of 4.30%.
(Matuszak, 2010)
The article of discussion lays the groundwork for the use of MPT in real estate investments.
Although there has been some significant advances in data collection, real estate property is too
unique for the use of MPT effectively. Additionally, there is no significant data to conclude that
allocating assets into different sub-classes or properties in different locations will minimize a real
estate portfolio’s risk. (Young, 1993. Pg. 2-13) Furthermore, real estate portfolios would need to
be consistently monitored and restructured to ensure an expected return is maintained. Without
concrete data on the expected returns of each property type, in an array of cities, this would
cause misleading results. Income producing properties will also have additional factors that will
not be seen when investing in stocks and bonds; for example property vacancies, property
expenses, or structural damage that requires repairs. The use of MPT could be very beneficial in
determining an optimal portfolio for a mixed portfolio; containing stocks, bonds, and real estate
assets. The use of MPT for a real estate portfolio, in this author’s opinion would not be benefical
due to the uncertainty of the results being accurate for individual real estate properties.
6
References:
Definition of "Naive diversification" - NASDAQ Financial Glossary. (n.d.). Retrieved November
16, 2015, from http://www.nasdaq.com/investing/glossary/n/naive-diversification
Doug. (2013). Multifamily cycles… where are we? Retrieved November 16, 2015, from
http://www.nspireassets.com/2013/07/01/multifamily-cycles-where-are-we/.
Fabozzi, F., & Modigliani, F. (1996). Capital markets: Institutions and instruments (2nd ed.).
Upper Saddle River, N.J.: Prentice Hall.
Harry M. Markowitz - Autobiography, The Nobel Prizes 1990, Editor Tore Frängsmyr, [Nobel
Foundation], Stockholm, 1991.
Hines, E. (2009). Application of Portfolio Theory to Commercial Real Estate. John Hopkins
University.
J. Michael Murphy, "Efficient Markets, Index Funds, Illusion, and Reality", Journal of Portfolio
Management (Fall 1977), pp. 5-20.).
Matuszak, A. (2010). Chapter 1 – Introduction to Modern Portfolio Theory - Economist at Large.
Retrieved November 16, 2015, from http://economistatlarge.com/portfolio-theory/introductionto-portfolio-theory.
Step 3 – Find the Lowest Standard Deviation. (n.d.). Retrieved November 16, 2015, from
http://economistatlarge.com/portfolio-theory/efficient-frontier.
Troen. Real Estate Development Processes I. Class Lecture #2. Real Estate Development
Program, Nova Southeastern University. 2015.
Wilson, S. (2000). Modern Portfolio Theory Applied to Real Estate. In Modern Real Estate
Portfolio Management (Vol. Ch. 19, pp. 209-217). New Hope, Pa.: F.J. Fabozzi Associates.
Wuerzer, T. Marketability and Feasability for Real Estate. Class Lecture #1. Real Estate
Development Program, Nova Southeastern University. 2015.
Young, M., & Greig, D. (1993). Drums Along the Efficient Frontier. Investment Performance of
Individual Properties Depends Less on Property Type and Location than Generally Believed, 213.