A quantitative approach to real estate asset allocation for balanced funds

Conventional market cap weighted portfolios lack diversification, which has the potential to lower their returns and increase risk. 

In UK commercial real estate, the market has been segmented by use and geographic location. This traditional IPD / MSCI market segmentation reflects a 36% exposure by use to retail using MSCI’s Global Property Classification Sectors; and a 50% exposure by geography to London and the South East.

This paper explores how real estate investors and portfolio managers can adapt the way they construct balanced portfolios by borrowing from current capital market practice surrounding factor investing. In Part One, the paper briefly looks at the work of academic financial research in the second half of the 20th century starting at Modern Portfolio Theory and going on to consider the Capital Asset Pricing Model, the Efficient Market Hypothesis and the growth of passive investing and Exchange Traded Funds (ETF’s).

The paper then switches its focus to real estate, noting that very many property portfolios are poorly diversified and carry high levels of specific risk, and suggesting that real estate fund managers should look beyond use and geography and build portfolios that are based around the underlying factors that drive performance.

MSCI research indicates that Quality factors can drive out performance. Our analysis of the published data suggests that a Value approach incorporating relatively high yielding and low MRV/m2 assets can drive out-performance at some points in the cycle whilst a Growth / Quality approach with a focus on low yield and high MRV/m2 can drive out-performance at different points in the cycle. There is also clear evidence to suggest that a Momentum based strategy could provide superior performance.