Real Estate Allocation Puzzle in the Mixed-Asset Portfolio: Fact or Fiction?

Abstract

Direct application of Modern Portfolio Theory (MPT) to the mixed-asset portfolio often suggests that allocation to real estate should be far more than what is practically acceptable. This paper reveals that the puzzling gap is caused by inappropriate application of MPT using only short-term (quarterly or annual) real estate performance measures. Our findings suggest that (1) the validity of MPT (the single-period model) to multi-period real estate investment is critically conditional upon the assumption that asset returns over time are independent and identically distributed (i.i.d.), and (2) the i.i.d. condition is strongly rejected by real estate data. As a result, real estate return and risk are holding-period dependent. We show that once real estate performance is measured over more realistic holding periods - which are longer due to illiquidity and high transaction cost - the real estate allocation puzzle appears to be fiction rather than fact.

Keywords: Mixed-Asset Portfolio, Asset Allocation, Real Estate