Limits to Diversification : Tail Risks in Real Estate Portfolios

This study addresses real estate's riskiness from a distributional viewpoint. Several studies have found real estate returns to be best modeled with stable paretian distributions. Using NCREIF individual property returns this is confirmed, but the first application of stable distributions to real estate portfolio returns provides evidence that diversification effects ultimately reduce the tailedness and surprisingly drive the tail parameter towards normality. The study further contributes to the literature by showing the importance of a complete view, beyond pure tail parameter considerations. Even in the presence of tail parameters being close to normal, the return risk may still be tremendous, and can only be reduced by diversification effects in property portfolios, and only to a certain time-dependent extent. The results have strong implications for risk managers, fund managers and holders of large commercial real estate portfolios alike