Decision theory and real estate investment: an analysis of the decision-making processes of real estate investment fund managers

Decision theory is the study of models of judgement involved in, and leading to, deliberate and (usually) rational choice. In real estate investment, there are models for the pricing and allocation of assets. These asset allocation models suggest an optimum allocation between the respective asset classes based on retrospective judgements of performance and risk. The representation and role of real estate in a multi-asset portfolio has, historically, been viewed in the context of portfolio theory. Real estate is selected, as other assets, on the basis of some criteria, e.g. commonly, its marginal contribution to the production of a mean-variance efficient multi-asset portfolio, subject to the investor's objectives and capital rationing constraints. However, decisions are made relative to current expectations and current business constraints. Whilst a decision-maker may believe in the required optimum exposure levels, as dictated by an asset allocation model, the final decision may|will be influenced by factors outside the parameters of the mathematical model. The focus of decision theory is on the mathematical models. These may be probability based, loss functions, or other forms of statistical representations of judgements. Yet, much of decision theory does not lie entirely within any one discipline: it draws upon psychology, economics, mathematics, statistics, social sciences and many other areas of study. This paper discusses investors' perceptions and attitudes towards real estate, and highlights the important difference between theoretical exposure levels and pragmatic business considerations. The lynchpin in the decision-making process is how investors perceive risk. The concept of risk plays a central role in various kinds of decision problems under uncertainty. It is possible that the definition of risk within an asset allocation model, where risk is equated with the uncertainty of achieving a specific required return, sits uncomfortably with the definition of risk used by the decision-maker, where risk may equate to the consequence of not matching the performance of the competitors. In this paper, the author discusses the behavioural aspects of the decision-making process for UK pension funds in their asset allocation role, and relates the various decision-making models to the that process. Whilst the apparent question being asked is 'how much should they invest in real estate?', the answer achieved must be viewed in the context of what is pragmatically possible, or institutionally acceptable, with the constraints of business risk considerations. Copyright © 2001 John Wiley & Sons, Ltd.