1. Chapter 21 Real Estate in a Portfolio Context © OnCourse Learning

2. Chapter 21 Learning Objectives  Understand the relevance of real estate investments in constructing portfolios of assets  Understand how the risk and return of a portfolio of assets can differ from that of the individual assets that make up the portfolio  Understand how diversification affects the risk of a portfolio  Understand what characteristics of assets are important insofar as constructing “efficient” portfolios © OnCourse Learning 2

3. The Nature of Diversification  A portfolio is a set of combination of assets  A mixed-asset portfolio is one that includes different types of assets  Diversification in real estate context means different property types in different geographic locations © OnCourse Learning 3

4. Measuring Risk  Risk – the possibility (and probability) that the actual return on investment will be different from the expected return  Measured as the volatility of an asset’s expected return  Expected return based on probable outcomes  Variance is the dispersion of the probable outcomes about the mean  Standard deviation is the square root of the variance © OnCourse Learning 4

5. Measuring Risk and Return 5 © OnCourse Learning

6. Diversification and Risk 6 © OnCourse Learning

7. Benefits of Diversification  Value is a costless reduction in risk by combining assets  Efficient frontier gives portfolios with greatest return for a given level of risk  Degree of investor’s risk aversity determines investor’s point on frontier © OnCourse Learning 7

8. Risk/Return Trade-Off for Two Assets 8 © OnCourse Learning

9. Efficiency Frontier 9 © OnCourse Learning

10. Theories of Asset Pricing © OnCourse Learning 10

11. Portfolio Construction with a Risk-Free Asset 11 © OnCourse Learning

12. Arbitrage Pricing Theory  Arbitrage Pricing Theory - asset return is a function of more than one index (return on the market)  CAPM is a special case of APT  APT doesn’t rely on a mean-variance efficient portfolio, but on asset pricing such that no arbitrage profits exist  Factors affecting assets’ returns: return on the market, inflation, industrial production, and return on the industry within which the company is located 12 © OnCourse Learning

13. Real Estate in a Mixed-Asset Portfolio  Problem with appraised values  Inside appraisals  Smoothing of risk  Sources of real estate data  Russell-NCREIF  NAREIT and commingled real estate funds  National Association of Realtors  U.S. Department of Agriculture  R.G. Ibbotson Associates © OnCourse Learning 13

14. Issues in Diversification  New equilibrium theory - excess returns to real estate based on unique risk  Residual risk - difficult for small investors to diversify based on cost  Marketability risk - lack of liquidity  Information risk - cost of obtaining information  Restricted portfolios for some investors © OnCourse Learning 14

15. Within-Real Estate Diversification  Diversification by property type  Geographic diversification  International diversification  Other methods of diversification © OnCourse Learning 15