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Housing investment in an
institutional portfolio context
A review of the issues
Joaquim Montezuma
Department of Urban Studies, University of Glasgow, Glasgow, UK
Keywords Residential property, Housing, Investments, Rental value, Portfolio investment
Abstract Residential property in a multi-asset portfolio context has been considered from two
substantially different perspectives: institutional investor’s and the household’s perspective. This
paper constitutes the first of two related surveys on the role of residential property in a multi-asset
portfolio. The paper provides an introduction to housing property investment at a macro level and
reviews the main empirical issues related to housing investment in an institutional portfolio
context. The literature in this regard generally supports the evidence that residential property is a
more effective hedge against inflation than both shares and bonds. Additionally, the reviewed
studies generally report that unsecuritised housing investment not only generates risk-adjusted
returns comparable to those of bonds and shares, but also exhibits low levels of correlation with
classic asset groups of institutional portfolios.
Introduction
Over the past 25 years, several empirical studies have been devoted to understanding
the risk-return characteristics of housing property and its contribution to risk
diversification within a mixed-asset portfolio according to Modern Portfolio Theory
(Markowitz, 1952, 1959, 1987).
The allocation of housing assets in a multi-asset portfolio – consisting of shares,
bonds and cash – have been studied from two different perspect ives. The first, the
household perspective, analyses the household’s optimal portfolio problem when
owner-occupied housing is included in the list of available assets and is discussed in
this paper. The second, the institutional investor perspective, analyses the potential
role of housing assets in an institutional investor portfolio, namely the role of housing
as a hedg e against inflation and its ability to diversify the institutional portfolio
investment and the paper dealing with this “Owner-occupied housing and household
asset alloca tion: a review of the issues” will be published in a forthcoming issue of the
journal.
The primary purpose of this paper is to review the main empirical issues related to
housing investment in an institutional portfolio context. Those empirical issues inclu de
residential property effectiveness against inflation and its diversification benefits in
a mean-variance Markowitz framework (Ibbotson and Siegel, 1984; Hartzell et al., 1987;
Hoesli and Hamelink, 1997).
The institutional allocation towards residential property may be justified by two
major financial reasons. First, housing property should help to reduce the risk of
a portfolio because as it has a low correlation with the classic asset classes
The Emerald Research Register for this journal is available at The current issue and full text archive of this journal is available at
www.em eraldinsight.com/res earchregister www.em eraldinsight .com/0263-7472. htm
Thanks go to Kenneth Gibb for his helpful comments and suggestions. All remaining errors and
omissions are the sole responsibility of the author.
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Received July 2003
Revised December 2002
Accepted December 2003
Property Management
Vol. 22 No. 3, 2004
pp. 230-249
q Emerald Group Publishing Limited
0263-7472
DOI 10.1108/02637470410545011
considered by institutional investors (that is, shares and bonds). Second, residential
property appears to provide a hedge against inflation, that is, the correlations
between housing ret urns and both expec ted and unexpected inflation are
substantially higher than zero.
In fact, the existing empirical studies suggest that unsecuritised housing
investment not only genera tes risk-adjusted returns compar able to those on bonds
and shares, but also provides low correlations with shares and bonds. This low
correlation means that housing property is an effective hedge against fluctuations
in the capital markets. Consequently and along with the modern portfolio theory,
residential property may be seen as a potential institutional investment class. On
the other hand, the empirical evidence about the ability to hedge inflation of
unsecuritised housing property has not been so consistent. One possible
explanation for this inconsistency could be the lack of standa rdisation in the
measurement of house returns. Despite the research evidence, there are weaknesses
with the housing diversification benefits argument. Namely, the lack of reliable
time-series data on housing prices and housing returns, and the limitations of the
simplistic modern portfolio theory framework that has been used on the reviewed
empirical studies.
This paper consists of three major sections. The first section gives an introduction
to housing proper ty investment at a macro level, that is, from a perspective
encompassing aggregates of many individual residential properties. The section
covers topics such as the linkage between the rented housing market and the capital
markets, modern portfolio theory, chara cteristics of housing investment performance
data, the portfolio allocation towards unsecuritised and securitised markets and the
possible implications of an increase in institutional investment towards rented
housing. The next section reviews empirical studies on inflation-hedging
characteristics of housing. The third section reviews the literature on risk-return
characteristics of residential property and its contribution to risk diversification of
institutional portfolios. The final section summarises and concludes.
Housing as an investment asset
To describe the linkages between the private rented housing sector and the capi tal
markets a three-market model, which distinguishes the markets for space, assets and
the market for general capital, is used [1]. Figure 1 presents a visual overview of this
model, including the major elements in and link ages between these three major
components. Studies on property market frameworks include those of DiPasquale and
Wheaton (1992), Archer and Ling (1997), and Geltner and Miller (2001).
The space market, where the usage of physical sp ace is traded, determines the current
rent for residential space. In this market the demand comes from the households
(tenants) [2] that use (consume) residential space. The demand for residential space
depends on rent, regional and national economies (e.g. interest rates, credit restrictions,
household income, regional employment prospects); demographics (e.g. number of
households, household composition, age of household); governmental intervention
(e.g. subsidy to the rented sector, direct provision of social housing – public renting
could be a close substitute to private renting); and technological factors (e.g. transport
and communica tion network features that change the meaning of distances and urban
location).
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On the supply side of the space market are the landlords (individuals and institutions)
[3] that produce housing services using the stock available. The new supply depends
on the cost of developing new housing stock, including the land cost, construction cost
and the developers’ cost of equity capital (“profit”). Consequently, new units will be
added to the current housing space market stock when the house values, defined in the
asset market, are equal to or exceed the marginal cost of new development and, as a
result, developers’ sh areholder value is increased.
The demand for residential space, together with the existing supply of private
rented housing [4], determines current rental levels and the expected cash flows of
a property.
The asset market, where the available housing assets are allocated among
competing investors, determines the house values. Asset supply comes from actual
housing owners (owner-occupiers and investors) willing to sell part or all of their
residential stock. O n the demand side of the asset market are the investors (individuals
and institutions). Examples of institutional investors are the property equity
investment vehicles, pension funds, life insurance companies and mutual funds.
The types of institutional investors and their involvement in the rented housing sector
vary from country to country across Europe. For instance, in countries like Switzerland
and The Netherlands, the allocation of institutional funds to private rented housin g has
been relatively significant. For instance, housing is the main Swiss institutional
property asset group, with average property portfolio allocations over 60 per cent
(Immo-survey, 2003). In contrast, in countries like the UK and Portugal the
involvement of institutional investors with private renting is virtually zero. Hoesli and
MacGregor (2000) state that weight allocated to property in institutional portfolios is
Figure 1.
Linkages between the
rented housing sector and
the capital markets
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usually inversely related to the importance of the residential owner-occupied sector.
Besides, Montezuma and Gibb (2003) draw attention to the fact that countries with
higher financial institutional ownership tend to have more institutional involvement
with the private rented housing (e.g. Switzerland, The Netherlands, the USA, Sweden).
Even though the UK has a considerable level of financial institutional ownership, the
allocation of British institutional funds towards private renting is virtually nil. The
lack of UK institutional involvement in the rented housing sector cannot be explained
only by tenure structure. In fact, the British behaviour could be largely due to cultural
attitudes to residential property investment. The relatively recent (post 1988)
emergence of the necessary conditions for a modern deregulated private sector in the
UK and the subsequent reduction in political risk implies that the sector, and
corresponding opportunities may only now be emerging (Montezuma and Gibb, 2003).
The new Housing Act of 1988 replaced the rigid rent control with a regime of
market-related rents for new tenancies. This new system introduced the necessary
arrangements for rent settin g that were reasonably fair between tenant and landlord,
restoring security of tenure to the decontrolled dwellings.
From the investor perspective, housing assets are thought of as consisting of a
series of contingent cash flows over time, whose amount and timing, are fundamentally
defined in the space market [5]. In that sense, housing assets compete in the capital
markets with other contracts promising a stream of future cash flows. Examples are
shares that entitle the owners to receive dividend and fixed-income securities such as
bonds. The performance of assets in the capital market is determined by the
perceptions of potential investors concerning the level and uncertainty of the assets’
cash flows.
As mentioned earlier, the housing assets compete with all other assets, real and
financial, for an allocation in investors’ portfolios. Modern Portfolio Theory states
that assets could not be selected only on expected return and risk on each asset [6]
but also on the correlation of returns for each and every pair of assets (for
example, shares, bonds, cash, housing, other property). Furthermore, taking these
co-movements into account results in the ability to form a portfolio that has the
same expected return and less risk than a portfolio constructed by ignoring the
interactions between assets.
According to Archer and Ling (1997), the risk level of the expected cash flows
produced by residential property is shaped not only by the degree of uncertainty about
future relative supply and demand for property space, but also by the covariability of
the expected cash flows with systematic economic risk factors, which are determined in
the capital market [7]. In other words, the risk premium [8] of housing inv estment
depends on the risk profile of the cash flows defined in the space market and its
relationship with the general capital markets.
The above relationship depends on the level of integration between two markets [9],
housing and general capital markets, which is determined by the extent to which assets
in these markets are affected by common economic factors. If the two markets are
significantly integrated then it is expected that a large asset substitution will occur,
with such substitution having a significant impact on price movements in both
markets.
One can speculate that the level of integration between housing and general capital
markets depends on the following factors:
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.
availability of well-structured residential vehicles, providing a route to indirect
investment [10];
.
regulation of lending on housing and specialisation of the housing finance circuit;
.
regulation affecting private rented housing; fiscal treatment of private landlords
and tenants relative to other sectors of housing and other forms of investment;
and
.
availability and quality of the information on the residential property market.
Whether the housing market and general capital markets (including other property
assets) are segmented or integrated and to what extent they are causally related, has
significant implications for effective portfolio diversification strategies. Modern
Portfolio Theory suggests that the greater the degree of integration of markets, then
the property price changes should be more closely and promptly related to the general
economic fundamen tals and therefore, the less important are the benefits from
diversification. However, if the drivers are different or inefficiency exists [11] in the
markets, there will be profitable arbitrage [12] opportunities for multi-asset portfolio
investment. That is, the investors have the opportun ity to exploit differences in the
risk-adjusted returns (or price of risk ) across different asset classes (e.g. residential
property and shares) and capital will flow accordingly across market segments until
price discrepancie s are corrected. In spite of this, frictions such as, illiquidity [13] and
information costs in the housing sector tend to decrease the profitability of the
arbitrage opportunities. Additionally, the degree of integration of housing markets and
general capital markets is also important for public policy issues related to market
efficiency and regulatory impediments to capital flows among two markets (Lin g and
Naranjo, 1999).
One can argue that the differences in the roles of institutional investors [14] in the
rented housing sector across countries are related to the different levels of integration
of housing markets and general capital markets in each of these countries. To put it
another way, the institutional investors start to consider housing investment as a
candidate for their portfolios once the degree of integration between these two markets
exceeds a minimum level.
From the above, housing markets can be viewed as an extension of capital markets.
This is not only due to the fact that housing is an alternative portfolio choice available
to investors but also because financing terms available on capital markets have a
significant effect on the return on housing. Even so, housing markets div erge from
capital markets in a number of ways. They face high governmental intervention [15],
investments are illiquid, indivisible and heterogeneous (both structural and locational),
information is expensiv e and they have a negotiated pricing process.
These special housing attributes make it impo ssible to have an accurate housing
market value at any given time. Thus, there will always be differences between the
housing asset’s observable valuations and the unobservable true contemporaneous
market values Geltner and Miller (2001). Those differences or errors are of two types.
The first type of error is a purely random noise in the index value levels caused by
estimation error. This type of error increases the volatility of the returns over time,
decreases positive first-order autocorrelation and reduces the apparent
cross-correlation between the noisy series. Thus, random noise error could make it
appear as if housing property is less correlated with commercial property than
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it actually is. Finally, this type of error does not affect the theoretical covariance
between returns and any exogenous series. The random noise will be more important
when the returns are based on transaction prices indices and when the size of the
portfolio is small.
The second type of error, the temporal aggregation error, results from the fact that
the value of the index in each period is derived from transactions taking place during
the index period; in other words, the value is a weighted average over the period
instead of a spot price at any given time. The temporal lagging does not have a
significant effect on the long-term returns but has an impact on the short-term returns.
Additionally, the temporal lag reduces the volatility of the observable returns
(smoothing returns) and increases the positive first-order autocorrelation. According to
Geltner and Miller (2001), it is plausible that temporal lag error will cause only a mino r
bias in the cross-correlation between two similarly lagged property series. The
temporal lag error will be dominant in large portfolios or when the returns are based on
appraisal price indices. This type of error could also be important if the regression
estimated is based on pooled transaction price data. Given this, the type of housing
price index used and the portfolio dimension (that is, the sample’s size dimension) will
have an effect on the quality and characteristic s of the housing returns and thus,
influence the volatility of the housing property times series as well as the correlation
between housing returns and returns on other type of assets (e.g. commercial property,
shares, bonds). Aside from this, a number of empirical studies indicate that share
returns are excessively volatile over small periods of time (Shiller, 1981; and Fama and
French, 1992). If so, one must be cautious about results of empirical studies on the
correlation between the return on hous ing and those on shares. According to Quan and
Titman (1999) a possible way to overcome this problem is to use share and property
price time series over longer holding periods.
One of the consequences of the difficulty of having a true contemporaneous housing
market value is the diminishing attractiveness of residential property in a portfolio
context.
There are two major ways in which institutional investors can allocate their
financial resources in the private rented housing sector: through unsecuritised or
securitised markets. In the unsecuritised market, residential property is traded directly
and its inco me stream is received directly by the institutions and is taxed in accordance
with the institutions’ individual tax liability. Internal staff with housing management
expertise or external property specialists manage the unsecuritized property. The
utilisation of internal staff has the advantage of achieving returns at a lower cost and
with better control (Ward, 1999). In any case, selecting and managing residential assets
requires knowledge of and competency in a wide range of residential-related issues,
including investment analysis, property performance management, reporting
techniques, appraisal procedures and property disposition.
In the securitized markets, residential property is traded indirectly, by the use of
investment vehicles, which specialise in investing in, and often actively developing and
managing, portfolios of property equity. For example, the property investment vehicles
can take a variety of organisational forms such as, residential property companies, real
estate investment trusts (REITs) [16], property unit trusts and single property
securitized investments. The structure of investment vehicles varies from country to
country and for each country it has changed over time. For instance, in the USA,
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open-end funds [17], the earliest vehicle, gave way to closed-end funds [18] in the
early-1980s, as investors desired more specialised portfolios and became disillusioned
with open-end funds’ lack of liquidity. In the 1990s, direct investment through separate
accounts, including co-investments, became the vehicle of choice, especially among
large investors.
According to Goetzmann and Ibbotson (1990), the risks and the returns of
securitised commercial investment are higher than those of unsecuritised commercial
investment and the correlation between those two return series is low. Other studies
(e.g., Giliberto, 1988) also suggest that returns on direct property investment are
weakly correlated with the returns on indirect property investment. Furthermore,
Geltner and Miller (2001) argue that property markets are characterised by a unique
dual market situation. In other words, the trading of property assets could be done in
two parallel markets: the unsecuritised market (for trading individual propertie s
directly) and the securitised market (for trading property investment vehicles). The
property valuations in the two parallel markets are not consis tent every time.
Normally, the price behaviour in the securit ised market tends to be ahead of the direct
investment in time
The securitised residential asset presents several advantages over the direct
investment for the institutional investors. They provide quality and efficient
management delivered by professional teams, a higher degree of liquidity and
geographic diversification benefits. Additionally, the indirect investment ensure s
distance between the investor and the tenants, minimising the potential poor publicity
that could occur. However, the indirect investment also presents some drawbacks.
For instance, it provides wea k investor control and, usually, poor tax efficiency, the
risks and the returns tend to be higher than those of direct investment, and it tends to
be more correlated to shares and bonds than the direct investment.
According to Crook and Kemp (1999) the UK institutional investors that
have already allocated funds in the private rented sector, preferred direct investment.
The reasons given for that prefe rence include tax efficiency, control over the
investment and synchronisation of investment returns with the property market.
Conversely, the institutional investors that are not yet involved in the residential rented
sector identified securitized property as the more promising way to allocate their funds
in the sector. The reasons given for that choice include liquidity, efficient and quality
management and protection against potential poor publicity.
An increase of the institutional funds’ allocation to private rented housing may have
implications for housing tenure patterns, the risk-return characteristics of residential
property and private rented stock and service quality. The reinforcement of private
rented provision that is likely to result from a higher institutional involvement may
contribute to satisfying the growing needs of special housing tenants groups,
particularly for new households, those who need to be more mobile and the elderly
(Priemus and Maclennan, 1998). According to Maclennan (1998), European
socio-economic trends such as “growing global economic competition”, “the ageing
of population”, “monetary union” and “the renaissance of city cores”, are likely to
increase housing demand in those special household segments.
One can anticipate that the stronger participation of institutional investors in the
rented sector will lead to an improvement of housing market efficiency. In fact,
the degree of market efficiency tends to rise since institutional investors will intensify
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the availability of systematic information about housing markets and will improve the
ability to incorporate relevant information on residential property values. Therefore,
the impacts of economic, demographic and policy trends will be more quickly reflected
in house prices.
Institutional activities such as large-scale trading and diversification are likely to
contribute to a higher liquidity of residential market, which in turn should further
increase efficiency and lead to a reduction in house price volatility (that is, the ho using
investment risk).
The size of institutions allows them to invest in large residential portfolios, and
hence, to benefit from better quality management and economies of scale (that is, lower
operating costs per amount of residential investment), which result in higher returns on
housing investment. Size also facilitates the geographical diversification across
regional housing markets in the same country as well as across national markets,
which in turn should permit further risk reductions. Altog ether, it appears that the
strengthening of institutional investors’ participation in the rented housing market
leads to an increase in residential risk-adjusted returns.
A natural consequence of institutional involvement in the rented sector is the
development of new financial products, such as derivatives based on underlying ho use
price indices, which all ow for the pricing and trading of residential investment risk.
These derivative products may not only assist institutions in hedging against their
residential investment, but also would allow households to hedge the risks associated
with homeownership.
A further suggestion is that institutional housing investment growth may lead to an
improvement in the private rented stock and service quality. The latter could be
achieved by establishing an industry-wide code of practice setting out minimum
standards for the management and maintenance of privately rented properties (Crook
and Kemp, 1999).
Despite these advantages, institutional investors’ participation in the rented
housing market may also have some drawbacks, one of which results from possible
institutional investors’ herd behaviour [19]. The concentration of residential property
in the hands of a few institutional investors, who may react similarly and
simultaneously to news, could cause an increase in volatility of the housing market,
and/or liquidity failures at specific periods of time. Additionally, herding by
institutions may entail a loss of diversification benefits (as the market moves together)
and expose investors (households and institutions) to major losses as house prices
deviate from the fundamentals. However, empirical evidence is lacking that
institutional investment managers do in fact exhibit significant herd behaviour
(Bikhchandani and Sharma, 2000). One can additionally argue that potential negative
effects of herd behaviour are less likely in the housing market than in the capital
market. That is because significant proportion of the housing stock is owner-occupied
and thus a high concentration of housing assets in the hands of institutions is
less probable.
Inflation-hedging characteristics of housing investment
The empirical studies on housing investment in a portfolio context have not always
been consensual, particularly in relation to housing inflation-hedging effectiveness.
One possible reason for this divergence coul d be related to the fact that those empirical
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studies use different housing total return estimation procedures [20]. First, the
measurement of housing returns may or may not incorporate risk premiums
(e.g. illiquidity premium and marketability premium). Second, the income return
component could be estimated under different assumptions (e .g. using a resid ential
rent index or using a constant rent-to-value ratio), which provide diff erent
approximations of the income component. Next, the measure may rely on securitised
or unsecuritised housing property. Finally, and particularly in regards to unsecuritised
investment, the measurement could be based on distinct types of housing price indices
(e.g. appraisal, repeated sales, hedonic) to calculate the appreciation return component.
Thus, the procedure used has considerable implications for the quality and
characteristics of the returns measured.
An early study on housing inflation hedging ability was by Fama and Schwert
(1977). The authors rely upon Treasury bill rates as a measure of expected inflation
from 1953 to 1971, to test the inflation-hedging effectiveness of private housing
property, government bonds, corporate bonds, shares and labour income. T he authors
conclude that US residential property returns (capital appreciation returns based on an
appraisal index) have a strong positive relationship to both expected and unexpected
inflation [21]. However, one should recognise the limitations of the data used. The only
type of housing property contemplated in the price index is insured single-family
homes Federal Housing Assocation (FHA). In addition, there is a time lag between
when the FHA collects the data an d when the data is reflected in the consumer price
index (CPI).
Likewise, Fogler et al. (1985) report a positive relationship between US housing
appreciation returns based on a transaction price housing index and inflation for the
period 1952-1983. Hartzell et al. (1987), using US commingled real estate fund (CREF),
find that a well-diversified portfolio of real estate provides a complete hedge against
both expected and unexpected inflation. Rubens et al. (1989) also test the hedging
effectiveness of various financial and real estate assets (including housing) against
actual, expected and unexpected inflation over the 1960-1986 period.
The total returns for housing property in this study are estimated according to the
following procedure. The appreciation returns are calculated as the annual change in
the home purchase component of US CPI and the income returns are obtained from a
rented index. They conclude that residential property is a complete positive hedge
against actual and unexpected inflation and an indeterminant hedge against expected
inflation.
Bond and Seiler (1998), using the added variable regression meth odology (AVRM),
also report that US residential property (using appreciation returns based on
a transaction price index) is a significant hedge against both expected and unexpected
inflation. Similarly, Ben-Shahar (2001) using appreciation returns based on a
transaction price index over the period 1990-2000 in 25 Israeli cities, finds that housing
provides an effective hedge against expected and unexpected inflation. In contrast,
such authors as Hoesli and Hamelink (1997) using the Fama and Schwert (1977)
methodology, conclude that Swiss housing investment (measured by a total return
based on a hedonic price index) was not a good short-term hedge again st the inflation
during the 1978-1992 period.
Concerning the ability of commercial securitized property to hedge inflation, Liu
et al. (1997), among others, report evidence that property securities (Property Trusts,
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Real Estate Mutual Funds, Shares of Real Estate Operating/Development Companies)
provide a ba d hedge against inflation. According to Liu et al. (1997), since there is
evidence that the unsecuritized property is an effective he dge against inflation, it is
reasonable to expect that security design should have some impact on the inflation
hedgeability of securitized property. Moreover, they suggest that those property
securities that better reflect the underlying property in a country (e.g. Swiss Real
Estate Mutual Funds and the French Societes Immobilieres d’Investissement [22])
should provide a superior hedge against inflation. In contrast, property securities that
behave in a similar way to tha t of common shares (e.g. Japan and UK) should provide
an inefficient inflation hedge.
Recent multi-country studies that have addressed the issue of the inflation hedging
effectiveness of property also conclude, however, that this type of investment is a poor
short-term hedge against inflation. For instance, using cross-countries data over the
period 1983-1996, Quan and Titman (1999) find that commercial property is a good
long-term hedge against inflation but a poor year-to-year hedge. However, since Quan
and Titman’s empirical study was ba sed on commercial property data instead of
housing property data, the results cannot be extrapolated, without further empirical
evidence, to the residential situation.
Anari and Kolari (2002), using house prices and the prices of nonhousing goods and
services, rath er than housing returns series and inflation rates as in previous studies,
examine the US residential inflation hedge from 1968 to 2000. The study utilises both
autoregressive distributed lag (ARLD) models and recursive regressions to investigate
the relationship between housing prices and inflation. The authors’ findings confirm
earlier evidence that residential assets are a good hedge against inflation in the
long-run. Additionally, they report that house prices are a stable inflation hedge over
time.
According to Geltner and Miller (2001), private property (commercial and
residential) is not a “perfect” hedge against inflation. The returns in the private
property market tend to be positively correlated with inflation but not perfectly
correlated.
Divergent theoretical explanations are offered for the empirical results on the
inflation hedgeability of property investment. Fisher and Sirmans (1994) have
presented a number of reasons why property would be an infl ation hedge when supply
and demand are in equilibrium. In the first place, construction (building replacement)
costs have a tendency to increase with inflation. Second, market rents can be increased
as the asset value rises [23]. Thirdly, when supply and demand are in equilibrium,
market forces tend to equate asset value with bui lding cost. Finally, special lease
contracts (e.g. gross leases with CPI adjustments) allow rents to move with inflation
[24]. Fogler et al. (1985) further claim that t he positive relationship between housing
returns and the inflation rate is the result of changing investor expectations concerning
the inflation hedgeability of property.
Conversely, Titman and Warga (1989), following Geske and Roll (1983), argue that
stock returns, inclusive of property investment vehicles, are the catalyst to changes in
fiscal and monetary policy, which in turn cause an opposite change in the rate of
inflation.
From the empirical literature and the theoretical arguments offered one
cannot accept, without prudence, the hypothes is that residential property is a perfect,
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short- and long-term, hedge against both expected and unexpected inflation. Despite
this, there is strong empirical evidence that housing returns tend to be positively
correlated with inflation, and residential property is a more effective hedge against
inflation than both shares and bond s.
Diversification benefits of residential property for institutional investors
One of the earliest studies of the relative ability of housing to diversify institutional
portfolio investment is that of Ibbotson and Siegel (1984). The study compares the US
property returns (commercial, farm and residential) with those of shares, corporate
and government bonds, short-term bills and inflation over the 1947-1982 period.
The residential total returns are estimated according to the following procedure. The
capital appreciation component is calculated as the annual change in the home
purchase component of the CPI, not seasonally adjusted, and the income returns are net
of operating expenses. The paper reports that the housing returns have been between
those of shares and bonds and that housing returns are lowly correlated with the
returns on the financial assets analysed. Furthermore, they accept as ‘probable’ that
those small correlations with shares and bonds make residential property a
diversification opportunity for portfolios concentrated in shares and bonds. However,
there are at least two problems related with such housing return mea surement: the
procedure used to estimate the appreciation component and according to the authors,
the imperfect marketability [25]. The finding that residential property returns are lowly
correlated with those of shares is consistent with the theoretical explanation raised by
Summers (1981). Summe rs argues that the non-neutral effect of inflation on the US tax
system, through the differential change on house and share prices, can justify much of
this low statistical relationship between the housing market and the share market.
Hartzell et al. (1986) use a capital appreciation return, based on an appraisal price
index, to evaluate the diversification benefits of US residential property investment in a
portfolio context for 1973 to 1983. The authors’ findings confirm earlier evidence that
housing assets offer attractive diversifi cation opportunities for stock and bond
portfolios along with considerable inflation hedg ing. Additionally, they report that
residential property is weakly correlated with the non-residential property
(e.g. industrial, office, hotel, and, to a lesser extent, retail). Thus, housing investment
seems to provide a property diversification opportunity. That is to say that housing
investment could play a potential role within portfolios of different property types.
However, since all of the property segments analysed can offer diversification benefits
to financial assets and, since diversification across property segment s involves high
cost and the administra tive burden of selecting and managing the investment, the
former conclusion is not clear.
Goetzmann and Ibbotson (1990) analysed residential property using two different
types of indices. The first is the Home-Purchase Index of the US Government, which is an
appraisal index. The second is a hypothetical well-diversified portfolio of residential
assets. The later index, estimated by Case and Shiller (1990), is based upon repeated
transaction sales during the period 1970-1996 in four US housing markets
(San Francisco, Atlanta, Denver, and Chicago). Once again, the authors report that
residential investment total returns outperformed long-term government bonds but
underperformed the stock market, and that the volatility of ho using investment are
considerably lower than the volatility of the share and long-term government bonds [26].
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The authors find that returns on residential property have a strong negative correlation
with the returns on long-term government bonds and on shares, and a strong positive
relationship with inflation. Additionally, they report that returns on housing are only
slightly correlated with the returns on commercial property. The authors argue that,
given the low correlation between residential property and financial assets; housing
assets are a potential candidate in optimal mixe d-asset portfolios, even if ho using
returns are expected to be relatively low and the volatility to be relatively high.
Goetzmann and Ibbotson (1990) also demonstrate that substantial reductions in risk
may be achieved by diversifying regionally in residential property.
Hutchison (1994) analyses the performance of UK housing assets in
short-to-medium holding periods, both in absolute terms and in comparison with
financial assets (shares and government bonds) over the 1984-1992 sample period.
The residential total return is estimated according to the following procedure.
The appreciation component is calculated as an annual change in a housing price
index, and the income return is assumed to be a constant percentage of the capital
value. The housing price index used is based upon opinions of the district valuers
derived from sales information in their possession. The author reports low levels of
correlation between the return on housing and those on shares and government bonds.
In contradiction to previous studies, the computed data suggest that the returns
adjusted for risk on housing investment underperformed those on both shares and
government bonds during the sample period. However, the housing series used
does not extend through a complete housing market cycle, including boom and bust.
Thus, the data could not be sufficient to draw definitive conclusions about long-term
historical risks and returns of housing investment in UK. Conversely, since the housing
price index is based upon opinions, the time series probably suffers from smoothing
problems.
Liang et al. (1996) investigate the performance of apartments in a context of optimal
multi-asset portfolios, using US housing real estate investment trusts (REITs) instead
of unsecuritised housing investment. This approach carries two problems. First,
the percentage of US REITs that invest exclusively in housing is low. Second, the
behaviour of securitised and unsecuritised property does not always exhibit the same
pattern. In order to overcome the problem, Liang et al., construct a “double hedge”
apartment REIT index for the sample period between 1982 and 1993. This index
removes the return components of market share in general and non-apartment equity
REITs from REITs that invest in apartment property. They report a weak relationship
between unsecuritised housing and stocks an d bonds, and a strong, positive
relationship between direct and indirect housing investment. In addition, they suggest
that there are potential benefits of housing (securitised and unsecuritised) allocation on
efficient mixed-asset portfolios.
Hoesli and Hamelink (1997) analyse the residential property diversification benefits
to multi-asset portfolios duri ng the period between 1981-1992, in two Swiss housing
markets (Geneva and Zurich). The housing total returns are estimated according to the
following procedure. The appreciation returns are calculated as the annual change in a
hedonic price index, and the income returns are computed on the basis of a constant
rental return, in which a 150 basis points for operating expenses were then subtracted.
The authors confirm earlier evidence that housing assets provide diversification
benefits for multi-asset portfolios even though the illiquidity of residential property is
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accounted for (they use illiquidity premiums of 50, 100 and 150 basis points).
Additionally, they find that an investor who holds housing in one Swiss housing
market would also gain benefits from investing in another Swiss housing market when
only the housing investment asset’s class of the portfolio is considered.
Ben-Shahar (2001) relying on a capital appreciation return based on a transaction
price index over the period 1990-2000, finds that the returns adjusted for risk on
housing investment in Israel outperformed those on both the shares and bonds
according to both Jensen and Treynor indices and slightly under-performs according to
the Sharpe Index. Furthermore, the study shows evidence that housing assets’
allocation has potential benefits on optimal mixed-asset portfolios. This result is due
primarily to the weak correlation between residential property returns and financial
assets over the period.
Montezuma and Gibb (2003) evaluate direct residential as an institutional asset
group in three European countries (Switzerland, The N etherlands and Sweden) where
the involvement of institutional investors in the private rented sector is significant
compared with other countries in Europe. The three criteria used to evaluate residential
property as an institutional group include:
(1) private rental market value relative to institutional wealth;
(2) mean-variance performance; and
(3) hedge against inflation.
Regarding the first criteria the authors find that the value of the potential private rental
market is sufficiently large to provide institutional diversification benefits.
Additionally, they find, using a bootstrap analysis, that the risk-averse institutional
investor may obtain significant diversification benefits from investing in housing.
Finally, the paper reports that housing appears to be a good hedge against inflation in
Switzerland and Sweden.
One must be conscious that a variety of factors other than those considered in the
simplistic modern portfolio theory framework drive the strategic asset allocation
decisions of institutional investors.
First, the classic mean-variance framework ignores the presence of liabilities in the
decision process [27]. This is not completely realistic since one of the majo r
institutional investment policy objectives is to ensure sufficient assets to meet
liabilities. In other words, the institutional investors must also tailor their asset
holdings to hedge their liabilities. Accordingly, Chun et al. (2000) following Sharpe
(1990) argue that the maximisation of risk-adjusted future sur plus value (equal to
assets minus liabilities) can imply that pension funds’ allocations are different to those
suggested by the simplistic mean-variance framework. Thus, the institutional
allocation can be best seen in an asset-liability context, where the net wealth portfolio
(present value of future liability obligations minus present value of asset holdings) is
optimised, rather than in an asset-only context.
Second, the overall market for an inv estment opportunity must be sufficiently large
in order to provide significant diversification benefits (Muralidhar, 2001). Since the
private rented sector in most of the developed countries represents a small percentage
of total housing stock and the vast majority of privately-rented houses are let by
individual landlords, the proportion of the stock available for the institutional investors
allocation is usually minor. It appears that this fact may possibly be an explanation for
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the low institutional investment towards private rented sector. However, one can
argue that this fact is more a result of the lack of institutional interest in the rented
housing than a cause of that disinterest.
Third, institutional investment strategies are established in relation to a benchmark
portfolio [28] against which the investment manager performance is measured (Hoesli
and MacGregor, 2000). Since the benchmark portfolio, due to the small-scale portfolio
effect, tends to have a low proportion of funds allocated to property, the investment
managers are reluctant to allocate significant proportions of funds to property class es.
Fourth, the empirical studies reviewed do not include international shares (and
international property) as an asset class, despite the fact that foreign-based equities are
usually considered eligible assets by institutional investors. Some studies (e.g. Gordon
et al., 1998) have shown evidence tha t when international shares are included in the
portfolio optimisation, the allocation towards property becomes less important.
Finally, the hypothesised ability of housing to generate improved portfolio
risk-adjusted returns may be modified when the multi-asset portfolio already inclu des
other segments of property investment (e.g . office, retail, industry), as the
diversification across property segments is costly.
Conclusions and further research
The reviewed empirical studies on inflation and residential property returns have not
provided a consistent answer about the degree of inflation protection which can be
afforded towards housing investment. In particular, tests using total returns
(appreciation and income components) have obtained weak results. Conversely, most
of the empirical studies that rely on appreciation returns as proxy for total returns
(based on transaction or appraisal price indices) report a complete hedging against
both expected and unexpected inflation. From this literature review one can argue that
the housing hedging effectiveness conclusions are more dependent on the way in which
housing return is constructed than on the nature of the underlying housing price index.
This argument is corroborated by the study of Rubens et al. (1989).
Inconsistent empirical evidence on the ability of housing to provide a hedge against
inflation could simply be a consequence of the lack of standardisation in the
measurement of housing returns and methodologies used to compute expected
inflation. Nevertheless, the literature reviewed suggests that residential property is
a more effective hedge against inflation than both shares and bonds.
With regards to potential benefits of diversification across regional housing
markets in the same country, the empirical studies again have not been consistent.
For instance, the diversification benefits of holding a multi-regional portfolio within
the UK and Switzerland, appear to be higher than those within Sweden. In addition, the
reviewed empirical studies suggest that there are diversification benefits from holding
a multi-state portfolio within the USA.
The positive, while small, correlations between housin g returns and those of
commercial property, suggests that residential property could have a potential
allocation role within multi-property portfolios.
The reviewed studies, though based on return series constructed using different
procedures and data sources, generally report that unsecuritized housing investment
not only generates risk-adjusted returns comparable to those of bonds and shares, but
also exhibits low levels of correlation with the classic asset classes of the institutional
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portfolios. As a consequence, residential property seems to provide an alternative
allocation to institutional investors looking for ways to hedge against changes in the
shares and bond markets. Moreover, since the correlation between housing and
commercial property is low, housing may well provide within-property diversification
opportunities. Therefore, residential property may still occupy a position in an
institutional multi-asset portfolio, even when the investment portfolio already includes
other property segments. However, since the different property segments are able to
offer diversification benefits to bonds and shares and since diversification across
property segments is expensive, the latter conclusion is not clear.
Notes
1. This three-market model is applicable to the income-producing housing (rented housing
sector). However, when the owner and the occupant of the space are the same, as is the case
of the owner-occupier sector in the housing market, the notion of two separate markets is no
longer applicable. In the owner-occupier sector acquisition of the residential asset and
acquisition of the use of residential space become a combined decision.
2. The tenants are competing with homeowners for consumption of residential space. In that
sense, the variables that determine the homeowner user cost (mortgage interest rate,
residential depreciation, maintenance and expected appreciation rates, housing tax
treatment) also have an indirect influence on the demand of residential space. However,
and as Geltner (1989) argues, the consumption benefit of housing ownership requires
ownership per se. Therefore, the assets traded in the owner-occupier and rental sectors
should be treated separately.
3. On the supply side of the residential space market we also find the owner-occupiers that are
simultaneously producers and consumers of housing services.
4. One note of caution in using this framework is that the three-market model ignores the social
rented sector.
5. Recall here that for the owner-occupiers the purchasing of a house and the purchasing of the
use space is one combined decision.
6. We use “return” to indicate the return on an investment over a particular span of time called
holding period return. Return will be measured by the sum of the change in the market price
plus any income (rent deduced from operational costs) received over a holding period divided
by the price of the asset at the beginning of the holding period. On the other hand, risk or
dispersion of the returns around the mean is measured either by the standard deviation or by
variance.
7. Systematic (non-diversifiable) economic risk factors such as interest rates, inflation, market
portfolio.
8. The risk premium is determined by the difference between the riskless interest rate and the
expected rate of return on the asset.
9. There are several studies about the integration/segmentation between commercial real estate
and capital markets. Unfortunately, the conclusions about this discussion are not clear. See
for example Ling and Naranjo (1999), Barkham and Geltner (1995) and Liu et al. (1990).
10. According to Jones Lang LaSalle (2000) the US institutional residential investment
experience suggests that it is the structure and management of vehicles that is key to
performance rather than the vehicle itself.
11. The studies in general conclude that the housing market is informationally inefficient.
Future excess returns to housing assets are partly predictable on historic information.
In spite of this, it is not possible to establish consistently a profitable trading rule because of
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high transaction costs in the housing markets. See Case and Shiller (1989, 1990), Poterba
(1991), Abraham and Hendershott (1996), Clayton (1998).
12. Arbitrage profit-making by buying an asset at low price in one market and simultaneously
selling in another market at a higher price.
13. According to Davis (2000) liquidity is the ability to transact a large volume of assets without
moving the price against them, anonymously and at low transaction costs. Silber (1970)
points out that if two assets are identical in all respects except that one has a well-organised
secondary market while the other has a poor secondary market, an investor in the latter runs
the risk of being able to liquidate his asset holdings only at a low price (compared with the
price offered for the security with the better market conditions).
14. According to Davis (1996) “Institutional investors may be defined as specialised financial
institutions which manage savings collectively on behalf of small investors, towards a
specific objective in terms of acceptable risk, return-maximisation and maturity of claims”.
15. The intervention of government in the housing sector has occurred through diverse
instruments, namely, taxation, subsidy, regulation and provision; intervention, which entails
some political risk. Political risk here is defined as the possibility that changes in policy
affecting the private rented sector (e.g. rent control) will influence a property’s investment
return.
16. The British Government announced recently the introduction of investment property trusts,
tax-friendly vehicles.
17. An open-end fund consists of a commingled fund that does not have a finite life and accepts
new investor capital (selling new participation units) and carrying out new property
investments. The liquidity of these types of investment vehicles is far from being completely
adequate for all situations that might arise, and redemption is usually subject to certain
restrictions and conditions. Property open-end funds have an additional problem with
establishing the current value of their assets, that arises from the fact that their properties
are sold infrequently. Normally, the participation units are priced based on appraisals.
18. Closed-end funds consist in a commingled fund that has a targeted range of investor capital
and a finite life. The units of these type of funds are traded over-the-counter or on stock
exchanges and may trade at a premium or discount from the net asset value per unit.
19. According to Bikhchandani and Sharma (2000) herding results from an obvious intent by
investors to copy the behaviour of other investors.
20. The period-by-period total return has two components known as the income return (income
paid out by the asset during the period) and the appreciation return (change in the capital
value of the asset during the period).
21. The expected rate of inflation is the difference between the nominal interest rate and the
forecast real interest rate. On other hand, unexpected inflation is the difference between
the realised inflation during the period and expected inflation at the beginning of the same
period.
22. According to Liu et al. (1997) the Societes Immobilieres d’Investissement invest more than
75 per cent in residential property.
23. This could not be always true for the housing market because of government actions in order
to restrict rental increases in the private rented sector.
24. Once more, this type of arrangement is more typical in commercial property leasing than in
housing leasing contracts.
25. The authors argue that marketability costs (information costs, search and transaction costs,
and heterogeneity costs) must be considered when property returns are compared with those
of financial assets.
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26. As Goetzmann and Ibbotson (1990) point out, for the individual homeowner, who does not
have a well-diversified portfolio of residential properties, the risk is much higher. The risk of
investment in an individual home over a year is closer to 12 per cent than the 3 per cent for a
large portfolio of houses.
27. According to Muralidhar (2001), the pension fund equation determines that the sum total of
present assets, future contributions (funding policy), and future asset returns (investment
policy) must equal present and future liabilities.
28. The benchmark portfolio is the strategic long-term asset allocation of the investor that is
described by listing the various asset classes in which the plan is invested and the long-term
target allocations. Thus, the benchmark includes both large and small portfolios. Because
there are significant barriers to property investment (that is, cost and administrative burden
of selecting and managing the investment), the small-scale portfolios usually do not have a
propensity to invest in property (Ciochetti et al., 1999).
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Further reading
Case, K.E. and Shiller, R. (1987), “Prices of single-family homes since 1970: new indices for four
cities”, New England Economic Review, September/October, pp. 45-56.
Cho, M. (1996), “House price dynamics: a survey of theoretical and empirical issues”, Journal of
Housing Research, Vol. 7 No. 2, pp. 145-72.
Giliberto, S.M. (1992), “The allocation of real estate to future mixed-set institutional portfolios”,
The Journal of Real Estate Research, Vol. 7 No. 4, pp. 423-32.
Hendershott, P. (1996), “Uses of equilibrium models in real estate research’ paper presented at the
European Real Estate Society Conference, Stockholm, June, 1995.
Ling, D. and Naranjo, A. (1997), “Economic risk factors and commercial real estate”, Journal of
Real Estate Finance and Economics, Vol. 14 No. 3, pp. 283-307.
MacGregor, B. and Nanthakumaran, N. (1992), “The allocation to property in multi-asset
portfolio: the evidence and the theory reconsidered”, Journal of Property Research, Vol. 9
No. 1, pp. 5-32.
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