Efficient Real Estate Asset Allocation - Do Sector-Specifc Reits Outperform Diversified Reits?

Corporate focus, variously described as specialization, diversification or core competency ñ and the associated costs and benefits ñ is one of the fundamental and most discussed issues in business administration. Although the subject has been investigated by various researchers for real estate investment trusts (REITs) on an aggregate level, the findings regarding specialization or diversification strategies and performance within the REIT arena as well as the role of REIT sectors in single- and mixed-asset portfolios remains inconclusive. Therefore, the study investigates theoretically and empirically the performance and strategic relevance of specialized and diversified vehicles in the asset allocation framework for the case of listed U.S. REITs. In this way, the paper analyzes the (out)performance of REIT sectors, their role in single- and mixed asset portfolios, and the link between the degree of sectoral focus and outperformance. The findings provide evidence for a trend toward property sector specialization that started in the early nineties and appears to continue today. Moreover, the performance analysis illustrates that REIT sectors have diverse risk-return profiles and that specialized REITs significantly outperformed diversified REITs on a risk-adjusted basis in most cases. Furthermore, the optimization of single- and mixed-asset portfolios with REITs brings several insights: Firstly, REIT sectors play dissimilar roles in the asset allocation framework. Secondly, the higher the desired return, the higher the portfolios must weight specialized REITs. Thirdly, the respective REIT sectors differ in their importance for investors. Fourthly, the application of Modern Portfolio Theory requires a constant rebalancing of the portfolio. Finally, the regression analysis proves that there is a positive link between specialization and outperformance. The theoretical examination provides evidence that specialization leads to superior information and market insight and lower administrative and coordination expenses which creates value for investors. Moreover, it is shown that the management of specialized REITs outmatches diversified REITs, for example through enhanced selection and timing abilities. The possibility of buying specialized REITs implies that investors can easily change and choose ìindustry championsî or (sub-)sectors in line with their particular portfolio strategy. Consequently, they can diversify on the investorsí level. Contrarily, diversification strategies on the REIT level across sectors put the value at risk and increase informational asymmetries and agency costs. In conclusion, investors seeking diversified exposure to U.S. real estate should certainly consider REITs, but they should apply a differentiated sector- and manager-specific approach.