Real Estate Betas and the Implications for Asset Allocation

Real estate is an important asset class, but what specifically does real estate contribute to improve diversified stock–bond portfolios? The author decomposes real estate investment trust returns into their factor betas to show that real estate is a hybrid asset class, with returns explained by a rich mix of compensated risk factors plus uncompensated sector risk. He shows that the same is true for private real estate, but with the additional contribution to risk from misappraisals. It is the rich mix of common factors contained in real estate that can improve the Sharpe ratios of diversified, multiasset portfolios. He discusses the implications for asset allocation from the perspectives of mean–variance optimization of asset classes, the capital asset pricing model with efficient markets, and factor-based asset allocation. TOPICS:Real estate, portfolio construction