The Role of Real Estate in an Institutional Investor's Portfolio Revisited

Many papers have recently pointed out that institutional investors allocate only a very small fraction of their portfolio to real estate, much smaller than theory would dictate. This raises the question, are institutional investors underinvested in real estate equities? Or do we simply have the wrong priors? This paper is an attempt to provide some new insights into this asset allocation paradox. The key conclusions of the paper are several: First, unlike other assets, it would appear that real estate, and real estate diversification, pays off at the very time when the benefits are most needed, that is, when consumption growth opportunities are low. Second, real estate returns are predictable. In fact, the amount of predictability in real estate returns appears to be about the same as in stock returns. Third, real estate performs well in an asset-liability framework. Fourth, the chance of experiencing a large loss on real estate over a long horizon is quite small. We also report here that private sector commercial real estate investments represent between 6 and 12 percent of investable wealth in the United States. Thus, it follows (if one believes the capital asset pricing model) that if institutional investors were to invest more in real estate (up to 12 percent of their assets), they should be able to eliminate nonmarket or unique risk. All of this leaves us a bit dumbfounded as to why institutional investors hold only between 2 and 3½ percent of their assets in real estate.