Real Estate Investment: Education & Practice: Do the Theories fit the Applications?

Keith Lown & Michael WhiteNottingham Trent University

• Most degree programmes include classes on investment analysis – Modern Portfolio Theory and The Capital Asset Pricing Model

• Real estate investment constitutes a major research area• Theories used in equity markets usually taught in real

estate degrees

• But how relevant are these theories for real estate investment?

Investment Theory & Practice

Modern Portfolio Theory

Modern Portfolio Theory (and its spin-off The Capital Asset Pricing Model) won Nobel Prizes for 3 famous financial economists:

Harry Markowitz b.1927- University of Chicago- Modern Portfolio Theory (1952)

John Lintner b.1916, d.1983- Harvard Business School- Capital Asset Pricing Model

William F Sharpe b.1934- UCLA- A Simplified Model for Portfolio Analysis

The Market Model

• The expected return on an asset could be expressed as a linear function of the expected return on the market as a whole

Expected Rate of Return

Asset Specific variable

β Beta valueExpected rate of return

on market

• Return on any asset related to a common index (the market as a whole) rather than on each other (as in MPT)

The Capital Asset Pricing Model

Calculation of β Beta:

Covariance of rate of return on the asset and portfolio

Variance of the rate of return on the market

β Beta Values

β = 1 asset/share rises and falls in line with the market

β = >1 asset/share rises and falls are more volatile than the market – Aggressive Asset

β = <1 asset/share rises and falls fluctuate less than market - Defensive Asset

β = 0 asset/share has no risk

Used Extensively in Analysis of Equities Markets

The Capital Asset Pricing Model

Equities Beta Calculations

CAPM Vocabulary has crept into Real Estate…

• Formula for the single asset portfolio including Beta

Theory and Practice

Research• Are these models used by real estate

investors/fund managers?• Can they be adopted?• Should they be adopted?

• Clear limitations when considering the practicalities of investing in what is an imperfectly traded market with lumpy assets

• Is it appropriate only as top level asset allocation and not at sector selection?

Asset allocation

Funds

Real EstateBondsEquities

Direct Indirect

Asset allocation

Funds

Real EstateBondsEquities

Direct Indirect

Offices Retail Industrial Other Indirect

Asset allocation

Direct

Offices Retail Industrial Other

City Centre

Out of Town

BusinessParks

High Street

Retail Parks

Shopping Centres

Logistics Estates Hotels Student Resi. Leisure

Shopping Centres

Regional Dominant Town Centre Suburban

Town Centre

Prime Secondary Tertiary

Where can MPT/CAPM be employed?

MPT/CAPM?

MPT/CAPM?

MPT/CAPM?

MPT/CAPM?

MPT/CAPM?

MPT/CAPM?

Asset Allocation• No consideration of international investment• Is, can or should CAPM be used in determining allocations to

direct real estate?• If not, why teach it on real estate courses?

• Primary drivers for real estate investment = returns and liquidity not necessarily diversification

Research MethodologyQuantitative Research• Structured interviews with property fund

managers

Qualitative Research• Is this even possible in that historic

performance data for individual properties is not available in a format that can be useable?

Research MethodologyStructured Interviews with Property Fund managers.

Areas to be covered:

The asset allocation process utilised?Structure characteristics of their funds?Decision Making ProcessPortfolio AllocationRole of DiversificationBenchmarking provisions

The Pilot StudyEarly Indications from 3 UK Fund Managers

The money coming into property is ever

more sophisticated…

We have to speak the right language

Property is small beer compared to

Equities

There just isn’t the data to use CAPM

properly

CAPM can be another way of

analysing real estate assets

Property does not lend itself to such

analysis

We are more interested in risk

management

It is worthwhile teaching but…

These tools are only used at a top level

asset class allocation

Real Estate Investment Education & Real Estate Investment Practice:

Do the Theories fit the Applications?

Keith Lown & Michael WhiteNottingham Trent University

Questions?