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Some diversification benefit in particular allocations.
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Real estate investment represents a significant part of many institutional portfolios. Since real estate is not directly traded on a centralized exchange, the physical real estate market is characterized by a relative lack of liquidity, large purchase size, and high transaction costs for properties that are fixed at some location and heterogeneous. The low transparency of the real estate marketplace results in potential asymmetric information. Further, the lack of frequent transaction data for the analysis of return distributions often necessitates the use of appraisal-based series. Real estate provides a source of relatively high risk-adjusted returns to investors who can obtain costless but good-quality information.
This article explores the benefits of direct and indirect real estate investments. As for other less liquid investments (e.g., hedge funds, emerging market debt/equity), exchange-traded shares of real estate investment companies (real estate investment trusts, REITs) provide investors with a liquid exposure to real estate via standardized financial securities in an organized, efficient, and transparent market where frequent transaction-based data are readily available (see Chan, Leung, and Wang [1998]). An increasing number of ETFs on REITs enable investors easy access to a diversified real estate portfolio. Note, however, that these instruments represent an exchange-traded market price for the REITs, not necessarily the actual market value of the underlying assets.
Our results indicate that direct real estate investment offers some diversification benefits to an established stock and bond portfolio, while securitized real estate may not. Thus investment in shares of real estate investment companies does not substitute for direct real estate investment.
BACKGROUND
The academic research on real estate investment focuses on three principal areas: 1) indexing, and measurement issues in the real estate market; 2) the risk-return and diversification properties of real estate investment, both internationally and within specific markets, and asset allocation issues; and 3) the economic determinants of returns in real estate.
Real Estate Indexes
Exposure to the real estate market can be achieved via two principal modes of investment-direct and indirect (securitized or financial). Direct real estate investment involves the acquisition and management of actual properties. Indirect investment involves buying shares of real estate investment companies (such as REITs) or investing in the...