International diversification opportunities for real estate investment portfolios : a fresh look focusing on private real estate after the Great Crash

This thesis explores the topic of diversification opportunities in international real estate, with focus on private real estate markets in developed countries. In examining the characteristics of returns and interrelatedness between international real estate, stocks and bonds markets from the time period spanning 2000 to 2009, we find that 2008 was the only year within the past decade in which several countries saw synchronized negative returns on a calendar year basis in the stocks and real estate markets, and even so the synchronized negative returns was only experienced by half of the countries within the 10-country opportunity set. The amplitude of the peak to trough drop in the cumulative value of the assets was small in real estate on average relative to that of stocks. These findings suggest that investors' should benefit from holding international real estate within their portfolios, even in an extreme down market. Modern portfolio theory is used to analyze and compare ex-ante diversification opportunities in international real estate, stocks and bonds and domestic diversification opportunities for the three asset classes from the perspectives of U.S. and European investors. We project expected returns for each of the markets and used historical risks (volatility) from the 2000-2009 period as estimates for volatility. When returns are calculated in local currencies, international diversification in the real estate portfolio (diversified within a 10-country opportunity set) should help U.S. investors substantially improve their portfolio risk-return efficiency relative to domestic diversification (within a 6-metropolitan area opportunity set), as the markets within the U.S. domestic opportunity set provide unattractive risk-return efficiency and their movements are highly correlated. By contrast, European investors will benefit less from the same international diversification strategy relative to domestic diversification (within 5 Eurozone countries) as several Eurozone markets are able to provide considerable risk-return efficiency and low correlations can be found in some pairs of markets. Applying home bias and limits on exposure to any single country i.e. country caps to the portfolio allocation helps to balance the allocation weights for the investor's portfolio but also significantly limits the investor's ability to take advantage of diversification opportunities provided by the international markets. When returns are calculated in the investors' domestic currencies, additional currency risk increases the portfolio volatility without providing additional expected return, reducing diversification benefits of international real estate. Even so, international diversification potential to U.S. investors should still be considerable, while that to European investors' should be minimal.