Optimal allocation to real estate incorporating illiquidity risk
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Shaun A. Bond* is a senior lecturer in real estate finance in the Department of Land Economy at the University of Cambridge. He Holds a PhD in Economics from Cambridge and has considerable experience in economic analysis as both an academic and as a senior economist in the public sector. Shaun’s current research interests are centred on the application of quantitative techniques to decision making in real estate and more generally in other areas of finance.
Soosung Hwang is a reader in finance at Cass Business School, London. He has a PhD from the University of Cambridge. He worked as a senior research associate in the Department of Applied Economics, University of Cambridge, before he joined Cass Business School. He has also worked as a fund manager and a consultant in financial consulting firms. His research area covers various topics in finance and financial econometrics such as asset pricing, emerging markets finance, behavioural finance, real estate finance, structural breaks and long memory, volatility processes, forecasting etc.
Kimberley Richards holds a MPhil in Real Estate Finance from the University of Cambridge and a combined degree in Commerce and Property from the University of Auckland. She is currently working as an analyst at Cushman & Wakefield in London. *Department of Land Economy, University of Cambridge, 19 Silver Street, Cambridge, CB3 9EP, UK. E-mail: [email protected]
Abstract This paper considers how the illiquidity risk associated with the uncertain marketing period of a commercial property affects the allocation to real estate assets in a mixed-asset portfolio. Using the model of marketing period risk discussed by Bond et al. (‘Marketing Period Risk in a Portfolio Context: Theory and Empirical Estimates from the UK Commercial Real Estate Market’, mimeo, Department of Land Economy, University of Cambridge, 2005) and UK asset return data, the study finds that the allocations to real estate in a portfolio with a short holding period (one year) fall dramatically following the incorporation of the illiquidity risk into the analysis. For longer holding period portfolios (five years), however, the impact of the illiquidity risk on portfolio allocation is less significant. The results do not explain the large discrepancy between observed portfolio allocations to real estate and the allocations suggested from standard mean-variance models. Illiquidity risk appears to be a contributing factor, but it is not the main driver of low actual allocations to real estate in UK pension funds. Keywords: illiquidity risk, commercial real estate, asset allocation
Introduction Theoretical studies suggest that direct investment in commercial real estate can enhance the risk-return profile of a diversified portfolio (Hudson-Wilson et
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Journal of Asset Management
Vol. 7, 1, 2–16
al., 2003), and the optimal allocation is typically found to be in the range from 15 per cent to 20 per cent. Actual allocations to real estate, however, are substantially lower. For example, the
䉷 Palgrave Macmillan Ltd 1479-179X
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