Identifying Real Sources of Risk and Diversification

Purpose - To examine whether current decision-making approaches and tools are effective for investors seeking risk-adjusted returns in private equity real estate. Two problems in particular are examined: first, over-reliance on geographic, sector and style labels; second, excessive emphasis on volatility of total returns (which is problematic because total return data mask the marked difference between the volatility of income returns and capital returns). Long term and short term improvements are suggested. Design/methodology/approach - Analysis of historic sources of risk and return at multiple levels and over different time periods, with focus on difference between income and capital returns. Findings - For investors whose priority is maximising risk-adjusted returns, better results are obtainable by looking through sector, geographic and style labels at the underlying cash flows. Long term diversification is more likely to be achieved through a combination of complementary income sources and lease structures than through naive geographical or sector diversification. The difference in volatility of income returns and capital returns merits greater attention. Research limitations/implications - Historic data is scarce outside the most mature markets. Practical implications - May help develop clearer understanding of real estate risk and improved decision-making for sell-side and buy-side market participants.