Replicating Expected Commercial Real Estate (CRE) Risk and Returns Using Liquid Market Instruments and CRE Market-Related Investment Risk

The purpose of this paper is twofold. First, we estimate forward looking risk and return characteristics of a theoretical commercial real estate portfolio employing real world hedonics with the goal of seamlessly integrating the asset class into a total portfolio risk management system. Because a factor model is at the core of the model’s analytics, the model is additive and we are able to calculate estimates at both the property and portfolio-levels. Second, we create liquid instrument portfolios that mimic the portfolio’s performance in order to hedge the portfolio’s risk or simply to gain exposure in the form of direct or collateralized investments in instruments such as stock and bonds whose characteristics would otherwise be unknown if investors were to rely solely on appraisals or index-based risk models. The paper hopes to show, not only what drives real estate risk and return, but also ask the fundamental question about ownership. If liquid synthetic portfolios can be efficiently built with a desired set of risk and/or return characteristics, why own the bricks and mortar? That is the fundamental question that all investors need to both ask and answer