The Application of Modern Portfolio Theory to Real Estate: A Brief Survey

Abstract

This paper will first outline the basic context of institutional investment in commercial real estate and note how MPT’s strategic approach can complement (but never replace) the industry’s traditional transaction disciplines. The follow- ing section summarizes how MPT has been applied and tested at three levels: (1) the macro decision of adding real estate to a mixed-asset portfolio; (2) the mi- cro decision of diversifying within a real estate portfolio, and (3) diversifying into international real estate. A long (and on-going) debate exists within the real es- tate investment literature as to whether it is appropriate to use MPT in real estate. The objections noted in this survey include problems with real estate data, the char- acteristics of the return distribution, and the contention that MPT abstractions ignore important features of the market and decision-making process. Researchers have ac- knowledged these objections and devised many possible solutions. After reviewing these responses, the paper ends with some reflections on areas for future research in real estate and how some of the lessons learned in real estate may be applied to hedge funds and private equity.