Real Estate in a Mixed Asset Portfolio: The Role of the Investment Horizon

Abstract

In this article, three often mentioned special characteristics of the real estate asset market –high transactions costs, lack of liquidity, and return predictability – are addressed in analyzing the role of UK commercial real estate investments in a mixed asset portfolio. Due to return predictability the annualized twenty-year standard deviation of both stock returns and real estate returns amounts to about 60% of the one-year risk. An illiquidity risk premium accentuates this result with regard to real estate. There are also considerable horizon effects in correlations. Over investment horizons between five and twenty years, and over a wide range of return targets, the weight allocated to real estate is between 13% and 87%. The allocation increases with the investment horizon, because the aspects of
transactions costs, illiquidity and return predictability all make real estate more favorable for long-term investors. In the long run, real estate appears to be a very good inflation hedge.
Traditional mean–variance analysis, i.e. ignoring return predictability, transaction costs and illiquidity, can be very misleading.