Applying MPT to Institutional Real Estate Portfolios: The Good, the Bad and the Uncertain

Executive Summary. This study examines the application of a modern portfolio theory (MPT)-based portfolio strategy to institutional real estate investment. Specifically, a real estate investment strategy based on property-type allocation (with a broadly diversified geographic mix), in keeping with the prevalent practices of institutional investors, is analyzed. While MPT yields optimal ex post portfolios, its use as an ex ante portfolio allocation strategy, however, can lead to mixed results. Two five-year ex ante subperiods are analyzed. During the first of these two subperiods, the MPT-based portfolio strategies under-performed a naive and an average-mix (representing the aggregate property-type weighting of institutional investors during the previous subperiod) strategy. In the subsequent subperiod, the MPT-based strategy outperformed both the naive and average-mix strategies. However, in neither of the subperiods did the ex ante MPT-based portfolio strategies generate portfolios on the ex post mean-variance efficient frontier, nor did the average-mix portfolio outperform the naive portfolio. Finally, the consistency of the risk dimension (but not the return dimension) of the ex ante MPT portfolios suggests stability in the covariance matrix which may be useful for mitigating ex ante risk.