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MODERN REAL ESTATE PORTFOLIO MANAGEMENT (MREPM) REAL ESTATE IN A CAPITAL MARKET CONTEXT, PORTFOLIO DIVERSIFICATION AND OPTIMIZATION APPLICATIONS TO WESTERN REGIONAL APARTMENT PORTFOLIOS E (r) • • • • • • • • • • • •• • • • • • • • • • • • • • • M ? Prepared by Lawrence A. Souza, CRE Principal – Real Estate and Financial Economist Johnson/Souza Group Special Research Consultant, BRE Properties, Inc. Doctoral Candidate, Corporate Finance, Golden Gate University 42 Jersey Street San Francisco, CA 94114 Message: (415) 826-5661 Direct: (415) 713-0213 [email protected] com OUTLINE I. II.

Introduction Risk Management and Institutional Real Estate Securities A. B.

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1. 2. 3. 4. 5. 6. C. 1. Institutional Real Estate Capital Markets Tends in Institutional Real Estate Capital Markets Institutional Real Estate Holdings Capital Flows Into Real Estate Emerging Institutional Real Estate Securities Capital Markets Optimal Size for Market Efficiency Institutional Trading of Real Estate Securities Frictionless Portfolio Construction and Diversification Risk Management and Institutional Real Estate Securities Risk Management Strategies: An Integrated Top Down/Bottom Up Approach Vertical Integration a. . Geographic Diversification Strategy c. Economic Base Diversification Strategy d. Catastrophic Risk Underwriting Property Level Diversification Strategy e. Economic Efficiency and Wealth Maximization D. III. Literature Review A. B. Modern Portfolio Theory (MPT) Modern Real Estate Portfolio Theory (MREPT) IV. Research Design I: Real Estate In A Capital Markets Context A. B. C. D. E. F. G. Introduction Capital Market Assumptions Methodology Discussion of Results Conclusions and Recommendations Research Criticisms Future Research 2 V.

Research Design II: Portfolio Diversification and Optimization Program A. B. C. D. E. F. G. H. I. J. K. L. M. Introduction Portfolio Diversification Portfolio Optimization Housing Market Variable Determination Multifamily Parameter Production Time Series Analysis Testing the Market Model Methodology Multiple Index Model Multiple Regression Model Results Portfolio Optimization and Determination Model Results Acquisition and Development Portfolio Strategy VI. Research Design II: Portfolio Diversification and Optimization Methodology A. B. C. D. E. F. G. H.

The Geographic Diversification Model Optimal Weights and Projected Annual Total Returns The Market Selection Model The Models Compared Metro Area Correlation Analysis Preliminary Economic Base Analysis Mitigating Industry Concentrations Integration of Results VII. Research Results II: Integrated Delphi Process A. B. C. D. E. Definition of Delphi Process Statement of Purpose Goals and Objectives Activities Survey Worksheet and Results VIII. Research Evaluation II: Expected Portfolio Performance Outcomes A. The Model Portfolio: Back Testing the Forecast Model 1. 2. 3. 4.

Results Objective Methodology and Analysis Variables and Assumptions 3 5. 6. Summary of Back Test Analysis Example of Metro Rankings over Time IX. Research Results II: Portfolio Performance Evaluation A. The Model Portfolio: Back Testing the Forecast Model 1. 2. Introduction Methodology a. External Data b. Internal Data: Asset Management and Research Analysis a. Benchmark Performance Ratios b. Positive Variance Measurement Implementation Results 3. 4. 5. X. Research Results II: Portfolio Evaluation – Dispositions/Exit Strategy A. Portfolio Asset Sales Decisions: Hold-Sell Analysis 1. 2. Introduction Methodology a.

External Data Internal Data: Asset Management and Research b. Analysis c. Benchmark Performance Ratios d. Positive Variance Measurement Implementation 3. 4. XII. Research Design III: Time Diversification Portfolio Strategies B. Western Metro Area Apartment Cycles and their Trends 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Introduction to Apartment Cycles Apartment Market Characteristics Total Return Comparisons Risk Comparisons Vacancy Rate Comparisons Effective Rent Comparisons Cycle Comparisons Methodology Assumptions and Limitations Statement of Research Questions Description of Population and Sample Data 12. 13. ANOVA/MANOVA Analysis and Results Concluding Remarks XIII. Contribution to Discipline XIV. References 5 MODERN REAL ESTATE PORTFOLIO MANAGEMENT: APPLICATIONS TO WESTERN REGIONAL APARTMENT PORTFOLIOS Introduction This report is a three part real estate portfolio research series that include: 1) Apartments in a Capital Markets Context, 2) Portfolio Diversification: Geographic and Economic Base Analysis, and 3) Modern Portfolio Theory: Arriving at Optimal Portfolio Weights. Portfolio benchmarking, exit strategies and time diversification strategies are also discussed.

This real estate capital markets research study is intended to: • • • Educate real estate portfolio managers and institutional investors with capital market theory and its application to real estate portfolios. Identify those portfolios (individual assets and real estate markets) that have exhibited high risk-adjusted rates of return in the capital markets over time. Examine historical relationships between portfolio risk and return and recommend portfolios based on high historical risk-adjusted rates of return, and those portfolios that appear to have reached their cyclical bottom and are poised for value increases.

The goal of this research project is to identify the optimal portfolio weights by geographic region for an institutional (REIT) existing and future apartment portfolio. The REIT’s current strategy is to acquire and develop in 14 metropolitan areas with in the western region: Albuquerque, Denver, Riverside-San Bernardino, Las Vegas, Los Angeles-Ventura, Orange County, Phoenix, Portland, Sacramento, Salt Lake City, San Diego, San Francisco Bay Area, Seattle, and Tucson. The mission of this project is to identify the optimal portfolio mix based on economic, demographic, and apartment market indicators.

Real Estate in a Capital Markets Context The first section of this report analyzes the risk-adjusted returns of competitive financial and real estate capital market assets (portfolios) and ranks them is descending order from highest to lowest. It is assumed that all capital market assets compete in the market for the finite loanable funds (savings) from surplus spending units (savers-investors) in the economy. The majority of investors is risk-averse and desires the highest return at the lowest risk.

If capital markets are assumed to be efficient, the majority of capital flows from savers and investors to those assets that have provided the highest risk-adjusted rate of return over time. Depending on the investors yield requirement, investors may also invest in assets with the highest (expected) return or invest in assets that will compensate them for taking on any additional risk. Speculators and contrarian or risk-seeking investors may invest in assets with very low returns or very high risk in anticipation of the possibility of achieving abnormal returns in the future. 6

This section of the study tries to prove, through objective research, that risk-averse (institutional) investors are better off investing in apartments, the West, and apartments in the West in the future. This study also looks at historical risk-adjusted returns for REITs and tries to prove that risk-averse investors are better off investing in Western apartment REITs in the future. Portfolio Diversification and Optimization Portfolio Diversification The first phase of the portfolio optimization project is to measure the correlation between economic variables and apartment returns within the 14 target markets.

The goal of these tests is to determine the degree to which economic or demographic variables help explain movements in apartment returns. Since apartment return data is limited, running these tests on the data that is available allows us to identify economic variables that are statistically significant in their predictability of future apartment returns. By using economic variables produced by government agencies and collected in and on a consistent basis, we can go back as far as the late 1970s, compared to the late 1980s for apartment return data.

The ability to go back to the late 1970s allows us to assemble a large sample data set. Under statistical theory, if the sample size is significantly large, it will approximate a normal (bell curve) distribution. The normality of the data is a prerequisite for using mean-variance analysis or modern (Markowitz) portfolio optimization techniques. Portfolio Optimization The second phase of the portfolio diversification study is to identify optimal portfolio allocations that achieve the highest expected rate of return at the lowest level of risk for the portfolio.

This phase determines the optimal portfolio weighting by geographic area. The goal of this phase is to compare the REIT’s portfolio diversification to a risk-return weighted (“target”) portfolio, then, from the variances, optimal v. s. actual allocations, a recommended acquisition strategy is structured to eliminate, to the extent possible, the risk of excess geographic concentration in the portfolio. Time Diversification The third phase of the portfolio diversification study is to identify stable real estate cycles across metro areas.

Investment in metro areas with long expansion cycles and short contraction periods reduces total portfolio return volatility (risk) and increases risk-adjusted returns (expected return). The determining factor in low long-term risk-adjusted returns is infinite land availability; resulting in inventory supply shocks, and higher probabilities that the metro area will enter hyper-supply (new construction) phases more often. Unconstrained real estate markets are more volatile, resulting in lower long-term total returns, occupancy rates, and effective rent growth.

Supply constrained markets have limited land availability, reducing supply shocks, and allowing the market to recover sooner. Weighting the portfolio with a bias toward supplyconstrained markets reduces portfolio volatility and maximizes risk-adjusted return. 7 RISK MANAGEMENT AND INSTITUTIONAL REAL ESTATE SECURITIES Institutional Real Estate Capital Markets Current trends impacting institutional real estate capital markets are the accumulation of large saving pools, continued securitization of real estate assets and decreasing capital flows into direct real estate investments.

This shift away from direct real estate ownership, managed and operated by real estate pension advisors, to indirect real estate ownership, managed and operated through real estate investment trusts (REITs) and real estate operating companies (REOCs), has caused many of these firms to reorganize and develop sophisticated risk management systems. The goal of these systems is to manage growth and mitigate dividend yield and stock price volatility. Lower volatility and correlations between stocks and bonds provides institutional nvestors with opportunities to reduce overall portfolio risk, warranting additional allocations into REIT/REOC securities. Additional allocations are projected to accelerate the development of the institutional real estate securities market. Real estate investment markets are notorious for their inefficiency, failures and asymmetric information; as a result, the institutional real estate securities market should provide benefits to the economy by allocating real estate capital flows more efficiently.

The efficient allocation and intermediation of real estate investment capital through REITs/REOCs provides deficit spending units with low cost capital and surplus spending units with higher investment returns. Lower social costs and higher public welfare are achieved through the elimination of high transaction and information costs associated with direct real estate investment. Trends in Institutional Real Estate Capital Markets Institutional Real Estate Holdings The importance of real estate as a legitimate asset class for investment and diversification purposes is exemplified by its contribution to total world wealth.

According to Ibbotson Associates, in 1991, of the over $43. 8 trillion in total world wealth, 48% is held in real estate, compared to 27% in bonds and 19% in equities; and of the over $15. 4 trillion in total U. S. wealth, 39% is held in real estate, compared to 23% in bonds and 28% in equities. According to these percentages most individual investors are over weighted and most institutional investors are under weighted in real estate from a global portfolio perspective. Although institutions are under weighted in real estate, they do hold a significant portion of the total U.

S. real estate market. According to Equitable Real Estate, May 1996, institutional investors owned $1. 28 trillion of the $3. 2 trillion total U. S. real estate market. Pension funds account for $114. 4 billion (43%) and REITs account for $56. 1 billion (22%) of the $254. 4 billion 8 in total equity holdings. Pension funds currently own 10. 7% and REITs own 8. 0% of the $1. 2 trillion institutionally owned commercial real estate market. As of June 1996, institutional holdings of direct real estate measured by the NCREIF Property Index totaled $53. billion, over 35% in retail, 32% in office, 15% in apartments and 12% in warehouse properties. Institutional investors–pension funds, life companies and mutual funds-now control well over 50% of the outstanding shares of publicly traded real estate investment trusts. Capital Flows into Real Estate Capital flows into real estate is determined through the diversification benefits received by including it in a multi-asset portfolio, but is mainly due to investor expectations for future financial performance.

Many investors are becoming weary of the stock market’s ability to continue to rise and are feeling that the market might be over bought. If equities are over priced, providing historically low dividend yields compared to other asset classes, then real estate assets are under priced in comparison. This disequilibrium in (arbitrage) pricing between the two capital markets will cause an increasing flow of investment capital into the real estate market, driving down current yields for real estate and drive up dividend yields for stocks.

Capital flows into the real estate market will continue until risk-adjusted returns and arbitrage pricing spreads between the two asset classes are equalized and traded away. Potential capital flows into real estate are enormous. The accumulation of new capital for real estate investments comes mostly from private savings of corporations and individuals. According to a recent ULI article, from 1990 to 1995, corporate net income rose 6. 5% per year from $581 billion to $798 billion, personal saving rose 7. 3% per year from $170 billion to $241 billion, and gross savings (public and private) rose 8. % from $722 billion to $1. 06 trillion. As of the first quarter of 1996 savings equaled investment, real private fixed investment totaled $1. 06 trillion. A significant portion of this savings and investment went into direct real estate investments and real estate related financial instruments. As of the second quarter of 1996, the NCREIF Property Index totaled over $53. 68 billion, up 6. 4% per year from $39. 36 billion in the second quarter of 1991; and from 1990 to 1995, the NAREIT index rose 46. 0% per year from $8. 7 billion to $57. 5 billion.

As of October 1996, REITs raised a record $8. 36 billion in 1996 through 100 secondary offerings. This compares with $7. 32 billion in 93 offerings in 1995 and just $3. 94 billion in 52 secondary offering in 1994. Supply and demand for real estate assets has become more balanced over the past five years and rents in most metro areas support new construction. Although the capital markets are currently aligned with supply and demand fundamentals, industry observers are concerned that public market and institutional investors will over react to improved market conditions, ncreasing the supply of investment capital, and creating capital flow pressures the market can not absorb. 9 The affect of these capital flows could drive down current capitalized yields on real estate assets to the point were new construction is justified to obtain higher yields. As the magnitude of capital flowing into the market increases, the probability of over building runs high. The risk of over building could parallel that seen in the mid-to-late 1980s.

Emerging Institutional Real Estate Securities Capital Markets Institutional investors are drawn to the REIT/REOC markets to create core portfolios, to balance the diversification of a private market portfolio, to co-invest, to arbitrage between public and private markets and to access larger property types and niches unavailable in the private markets. According to AEW Research, the average pension fund allocation targets 50% equities 45% in fixed income and 5% in other investments. Most pension funds admit their target real estate allocations are not fully funded and individuals are under-allocated evidenced by the only $2. billion in REIT -dedicated mutual funds, compared to a total of $1. 3 trillion in all stock mutual funds. An adjustment by institutions and individuals to a 6% allocation of their total investment portfolio would cause institutional investors to increase their investment flows into real estate by $100 billion and individuals by $65 billion, a total of $165 billion; this, along with the ability to take advantage of the up-and -down REIT structures, could push REIT market capitalization well above $200 billion. With financial institutions and infrastructure already in place, the REIT market could quadruple in size over the next five years.

The ability of REITs/REOCs to raise capital in four dimensions (private equity and debt and public equity and debt) gives them a significant competitive advantage over other market participants. As an emerging capital market, the REIT/REOC market has advantages over other markets that have developed in the past: the Southeast Asian equity markets of the early-1990s and the junk bond markets of the early-1980s. The advantages REITs/REOCs have are capitalizing in a financial system with well established monetary policies and controls, financial reporting and disclosure rules, financial ntermediaries and institutions and a developed financial market infrastructure with the latest information processing and telecommunications technologies. This system allows REITs/REOCs to raise capital in the public markets at relatively low costs and allows their issues to trade in liquid and established stock markets at relatively low transaction and trading costs. In comparison, the emerging Southeast Asian markets of the early-1990s saw significant flows of capital but were unable to handle these flows due to lack of monetary controls and central bank independence and inefficient, illiquid and thinly traded capital markets.

These characteristics were reflected in the volatility of stock prices and the inability of investors to exit the markets due to currency controls and lack of market participants. 10 In the early-1980s the U. S. saw the emergence of the junk bond market. This market, like the Asian equity market, was established due to relatively low yields being offered on comparative financial instruments at the time. These low yields were a result of the recessions of 1980 and 1982. Low current yields caused investors to look toward more riskier markets for returns.

The establishment of the junk bond market provided investors with the yields they wanted and corporate raiders with finance capital needed for hostel takeovers. Eventually, the lack of market capitalization and liquidity collapsed the junk bond market through successive Wall Street scandals and the S&L crisis. Optimal Size for Market Efficiency It is assumed that over the next five years the size of the REIT market will capitalize to the point were up to $1. 0 billion dollars in shares can be traded within a reasonable time period.

This will allow investors to convert their investments to cash without significant loss of value. Increased liquidity of the REIT/REOC market has been accompanied by an increase in share price, but increased liquidity will make these shares more sensitive to changes in the expectations of market liquidity. Growth in market capitalization has be driven by high expected returns in the stock market, low volatility in U. S. stock markets, continuation of rising capital flows from defined contribution plans into stock mutual funds, better alignment of interests etween management and investors and public market information and valuation. REITs are being accepted more and more by institutional and individual investors as the investment vehicle of choice due to low capital requirements for constructing a well-diversified multi-asset real estate portfolio. The growth of publicly traded real estate securities has improved the dissemination of data available to public and private market investors, information previously deemed proprietary and closely guarded. REITs/REOCs are continuing to make improvements in reporting, full disclosure standards and timeliness of new releases.

Liquidity of the public institutional real estate securities market will be dependent on improved information flows from an increasing number of securities analysts, traders and rating agencies. Increased liquidity that comes from a larger capitalized market will cause real estate security prices to become more sensitive to expected capital market in-flows. This sensitivity will cause higher volatility in REIT/REOC share prices. Volatility in share prices, as in interest rates, will spur the development of a real estate backed derivative securities market.

This market will improve market efficiency by allowing investment managers to hedge portfolio risk, investment bankers to hedge price movements prior to new issues and arbitrageurs to speculate between the options and stock markets. Increased speculator activity provides more liquidity to the market by improved pricing through the reduction of arbitrage spreads between the two markets. 11 Institutional Trading of Real Estate Securities Increased capitalization, information flows and liquidity has sparked institutional interest in real estate securities. REIT/REOC shares have been perceived to have lower liquidity than large-cap issues.

Lower liquidity requires higher yields, the current S&P index dividend yield is roughly 2. 0% compared to 7. 0% for REIT stocks. Large institutional shareholders have been averse to smaller-cap REIT/REOC stocks due to problems associated with trades moving the price, but in 1996 there were 97 REITs with capitalizations over $200 million, the size of most mid-size cap stocks. REITs are fairly heavily traded relative to their market size, but are less liquid by dollar size compared to large-cap stocks. Over the next five years market liquidity is projected to increase as market capitalization grows.

The REIT market is forecast to grow at a rate of 15% per year, based on historical averages. By the year 2007, REIT market capitalization could reach $300 billion and by 2017 over $1. 4 trillion. Efficient market conditions in the REIT market are just now being achieved, this is evidenced by rising volume, institutional block trades and off-market transactions. Friction Less Portfolio Construction and Diversification U. S. stock markets are the most liquid markets in the world due to standards of information disclosure and number of transactions and participation, leading to low cost trading.

Liquid capital markets provide for friction less portfolio construction and diversification. Increased disclosure and dissemination of financial information allows REIT/REOC shares to be bought or sold quickly at prices close to or at their current market value. With lower transaction and search costs associated with stocks, large institutional investors can implement tactical asset allocation programs to increase or decrease exposures to various sectors of the real estate market, while maintaining a core portfolio.

The ability of the investor to construct a securities portfolio of assets with varying unsystematic risks allows for risk reduction through portfolio diversification. The movement from a direct real estate investment portfolio to a REIT/REOC portfolio does expose institutional portfolios to greater systematic real estate risk. , because of the location specific characteristics of the real estate asset in a direct investment portfolio, but lowers the systematic risk of the overall mixedasset portfolio due to real estates positive correlation with inflation and negative correlation with stocks and bonds.

Risk Management and Institutional Real Estate Securities With the potential for enormous flows of capital into the real estate capital market REITs/REOCs must be able to manage these capital infusions and rapid growth associated it. REITs/REOCs need to rethink their organizational structure and implement well thought out risk management strategies. As capital flows increase there will be mounting pressure by institutional shareholders for these firms to accumulate properties and develop a well diversified portfolio.

The value of REIT/REOC shares will come mainly from the perceived strength of their management teams and quality of their real estate portfolio. 12 Risk Management Strategies: An Integrated Top Down/Bottom Up Approach As participation and involvement of institutional investors grow, REIT/REOC management teams will be required to develop and implement well designed risk management strategies. The core of these strategies will be an integrated top down and bottom up approach to portfolio construction and management. The top down approach will be research driven.

This approach draws heavily on the resources and skill sets of its research department, and emphasizes the utilization of real estate market and economic forecast models to select product types and geographic regions for potential acquisitions. Institutional investors, along with their advisors and consultants, screen and select REITs/REOCs based on their strategic plans and alliances, management teams, historical performance and market capitalization; and their ability to maximize cash flow, manage the balance sheet and access capital markets.

Premiums are being paid and additional funds are flowing to those firms having the organizational structures in place to handle large flows of investment capital and have risk management policies and a well defined portfolio strategy in place to mitigate portfolio risk from geographic and economic over concentrations. The ability to diversify and manage the core real estate portfolio is reflected in the firms funds from operations (FFO) and stock price volatility. Firms that meet or exceed FFO projections and have lower stock price volatility compared to their peers receive larger allocations from riskaverse institutional investors.

To mitigate FFO and stock price volatility, REITs/REOCs must vertically integrated and have successfully diversified their portfolio by geographic region and economic concentration, taking advantage of low to negative correlations between markets and employment over time. Vertical Integration First, the firm must be vertically integrated. The firm must be vertically integrated with a highquality seamless portfolio-property management and reporting system. The goal of this system is to facilitate information flows up from the property level and down from senior management.

This type of organizational structure eliminates problems associated with decision making based on incomplete (asymmetric) information, and makes for a more complete model of information disclosure and dissemination. With property management functions in-house the firm can take advantage of administrative and management economies of scale, achieving administrative cost savings through efficient payroll, property and portfolio level accounting and reporting systems. Firms with large and diversified portfolios obtain local market efficiencies and synergies obtained through a regional focus and use of regional managers.

Regional managers in association with property managers allow the firm to have better property level focus and management over the life of the property. 13 Geographic Diversification Strategy Second, firms must diversity their portfolio geographically. Geographic diversification reduces the risk of revenue loss caused by regional economic shocks. The goal is to have a large enough portfolio concentrated geographically to obtain economies of scale, but not overly concentrated to the point were economic shocks significantly disrupt portfolio revenue streams.

Geographic diversification is only one method of immunizing the real estate portfolio from over concentrations in economic risk. Economic Base Diversification Strategy The second method of immunizing the portfolio is to diversify across industries or employment concentration. By measuring the correlation between employment trends within each target market, and testing for correlations across time and economic groupings, portfolio management can determine the degree to which shared employment concentrations and shared employment movements between markets impact the portfolio.

Using Economic Base Diversification (EBD) analysis a diversification strategy with existing properties and potential acquisitions can be developed. Using geographic diversification strategies in conjunction with economic base analysis, an optimal portfolio structure can be identified and allocations achieving the highest expected return at the lowest possible risk can be calculated. The goal of this strategy is to compare the company’s portfolio diversification to an evenly weighted (“proxy”) portfolio. From the calculated variances optimal portfolio allocations can be derived.

These variances help guide future portfolio acquisitions and dispositions, eliminating the risk of excessive geographic or economic concentration. Catastrophic Risk Underwriting The third method of immunizing the portfolio is to diversify by product quality and geographic region with respect to the probability of catastrophic loss. An enterprise at risk is characterized by the fact that the fundamental nature of the operation is such that expenditures may exceed receipts during some accounting periods in the normal course of operation.

For example, over $35 billion in damage was wreaked in the 20 largest disasters in recorded Bay Area history, with the largest component coming from earthquakes, $15. 4 billion or about 45% of the total damage. Areas of major concern are areas along the Hayward and San Andreas faults. It is estimated that if there were a major earthquake along the Hayward Fault, it would force more than 300,000 Bay Area residents from their homes. The goal of assessing and systematically managing catastrophic risk is to determine what degree the real estate portfolio income stream is at risk of losses.

This is done by conducting deterministic and probabilistic loss analysis by property, geographic area and type of construction. Estimated costs of damage based on these probabilities determines optimal insurance (premium) coverage that protects the properties without over insuring. 14 By assessing the economic impact of catastrophic events on portfolio income, the REIT/REOC can devise a risk mitigation program consisting of either self-insurance (sinking fund), single insurer coverage, multiply insurer coverage or a multiple property and/or insurer strategies that minimize insurance premiums while maximizing coverage.

Property Level Diversification Strategy The bottom up approach to portfolio construction and management is submarket and product specific. This strategy is implemented by the acquisitions department and overseen by senior officers. This strategy relies heavily on the acquisition team’s experience in any given market and type of real estate being acquired. The value of this approach is reflected in the quality of local market contacts and relationships and the ability to move viable deals through the pipeline. The goal of this approach is to assess risks inherent in property-specific investment decisions, and nderstand the potential risks and returns of those decisions. This approach focuses on risk factors inherent by property type and class; factors such as vacancy loss, property life cycle and the potential use of leverage. A bottom up approach evaluates property performance based on market risks: inventory size, new construction, supply constraints, economic and demographic changes affecting tenant demand and investor sentiment. The end product is an evaluation system that prices assets and market risk premiums accurately within a portfolio context.

Economic Efficiencies and Wealth Maximization Over the next ten years, the REIT/REOC market will free up a significant amount of capital trapped in a relatively illiquid real estate market. Freeing up and dissemination of investment capital through securitization creates an efficient system of allocating scarce resources and provides a stimulus for long term sustainable economic growth. Efficiencies through securitization come from lower transaction and financing costs and providing capital to a capitalstarved sector of the economy. Through the use of real estate backed securities benefits accrue to providers and users of capital.

Investors will benefit by having access to markets once priced out of and the ability to move in and out of the markets quickly and cheaply. Overall, the more intensive use of real estate capital provides higher returns for investors and a lower cost of capital for users in the long run. 15 LITERATURE REVIEW MODERN REAL ESTATE PORTFOLIO THEORY (MREPT) Introduction Over the past twenty years, modern capital market theories have been applied to real estate portfolio development and management with mixed results. The difficulty in applying this theory is that underlying capital market assumptions due not hold-up well in real estate markets.

This is due to information asymmetries, high transaction costs, illiquidity, uniqueness of asset characteristics, private property rights, and tax and land-use legislation. The market is efficient, but it takes longer for it to arrive at market clearing prices. Theoretical constructs of modern capital market theory are extremely important when analyzing real estate as an asset class, and diversifier in a mixed asset portfolio: • • • • • • Expected Returns (Competitive) Variance of Returns (Lower) Covariance of Returns (Lower) Random Walk (Weak-Form) Efficient Market Hypothesis Systematic and Unsystematic Risks

Modern Portfolio Theory (MPT) Harry Markowitz, Modern Portfolio Theory Modern Portfolio Theory (MPT) was introduced by Harry Markowitz with his paper “Portfolio Selection” which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection and corporate finance. Modern Portfolio Theory explores how risk averse investors construct portfolios in order to optimize market risk against expected returns. The theory quantifies the benefits of diversification.

Out of a universe of risky assets, an efficient of optimal portfolios can be constructed. Each portfolio on the efficient frontier offers the maximum possible expected return for a given level of risk. Investors should hold one of the optimal portfolios on the efficient frontier and adjust their total market risk by leveraging or deleveraging that portfolio with positions in the risk-free asset. In a highly simplified world, the market portfolio sits on the efficient frontier, and all investors hold that portfolio, leveraged or deleveraged with positions in the risk-free asset. 16

Modern Portfolio Theory provides a broad context for understanding the interactions of systematic risk and reward. It has profoundly shaped how institutional portfolios are managed, and motivated the use of passive investment management techniques. The mathematics of MPT is used extensively in financial risk management. The Markowitz approach requires a large sample size of returns to approximate a normal distribution. One enough data is collected, and is normal in nature, mean-variance analysis can be used to approximate the optimal allocation depending on the pre-determined weight onstraints. Modern Real Estate Portfolio Theory (MREPT) Mueller, Pauley, and Morrill explain why institutional investors today must continue to consider both private direct real estate investments, as well as public or securitized forms of ownership, in order to develop an optimal portfolio that includes appropriate subcategories of real estate assets. Market depth, liquidity, asset quality, diversification, and price volatility are all considered strategically used portfolio management criteria in this must primer for the diversified portfolio investor (Mueller, 1995).

Institutional real estate investment – primarily pension reserve assets – grew rapidly in the 1980s. The fiduciary demands of a growing asset pool coupled with disappointing results in the latter half of the decade led to an increasing interest in the application of Modern Portfolio Theory (MPT) to the management of large-scale real estate portfolios. This paper reports the results of a study conducted in mid-1990 that surveyed the 426 largest institutional portfolios on portfolio management practices relating to diversification strategies, risk measurement, and evaluation of investment returns (Louargand, 1992).

The survey replicated several measures gathered by Webb in a 1983 survey to assess the rate of acceptance or utilization of ideas and techniques in the portfolio management community. Results indicate that change is perhaps slower than might be expected. Real estate performance measures have become more sophisticated in the past seven years with a shift away from accounting type measures toward fully discounted measures, including several variations on the Internal Rate of Return (IRR).

Risk-adjustment techniques have changed to the extent that portfolio managers have a greater likelihood of using sensitivity analysis, but few other innovation are widespread. Only a small percentage of respondents use traditional tools of MPT-based analysis, but the majority are cognizant of recent developments in the literature that attempt to show alternative methodologies for achieving true diversification within real estate portfolios (Louargand, 1992).

The results indicate that change is gradual and that some practices that have been discredited in the academic literature for many years may still be evident in the institutional community. 17 Styles of REIT Portfolio Management Investment styles and return objectives in real estate portfolio management have focused on higher return strategies: wealth creation, value added, income enhancement, and incremental risk. The ability of the REIT to achieve these goals through direct real estate (active) portfolio management is determined by management skills and experience.

Due to real estates illiquidity and asymmetric information flows, portfolio diversification and optimization strategies are followed over multiple periods. Where it may take a stock mangers weeks to adjust the portfolio to new optimal weights based on new return and risk information, it may take the real estate portfolio managers up to three years to adjust the portfolio, depending on size, market conditions, etc. (Stoesser, 2000).

When developing large institutional real estate portfolios, one of the main objectives is to identify and target outperforming markets based on high risk-adjusted rates of return. Factors used in determining target markets are: real estate market opportunities, demographic attributes, and market size. Due to the capital intensity, high transaction and information costs, most direct real estate portfolio managers underwrite properties on a buy and hold basis, extending the investment horizon.

This allows the manger to focus on long-term cyclical labor market and demographic trends. For example, the emergence of the echo-boomer and retirement of the baby boomers are expected to support apartment markets in the future (Han, 1996). There are many factors contribution to the supply of apartments: tax policy, capital availability, estimated demand by developers, etc. Statistically significant variables determining new apartment supply are: mortgage interest rates, housing affordability index, employment change, vacancy rates, and taxes (Giliberto, 1995).

Real Estate Portfolio Development Institutional real estate portfolio development is conducted in an integrated top-down/bottom-up fashion. Top-down analysis starts with national market and economic analysis, regional market and economic analysis, local market and economic analysis, and property level analysis; and then the process starts back up again. At the national level risks analyzed are: inflation, industrial production, risk premiums, term structures, business cycles, taxes, etc. at the regional level risks analyzed are: unsystematic risks, employment based and growth, demographic trends, income levels and growth, and vacancy rates; at the local level risks analyzed are: employment base and growth, demographic trends, income levels, vacancy rates, construction levels and costs, space utilization rates, and taxes; and at the property level risks analyzed are: physical characteristics, location and site characteristics, lease characteristics, property management expertise, and financing (Lieblich, Pagliari, 1996). 8 Opportunities for Diversification Historically, real estate has shown negative correlations with financial assets due to lease inflation indexation, and correlations between real estate markets have been low due to industrial concentration by geographic area. The ability to add real estate to a stock or bond portfolio, or diversify across geographic-industrial class, provides diversification benefits to portfolio mangers.

Volatility in institutional real estate portfolios emanates from two sources: 1) high risk/ return ratios, and 2) capitalization rate pressure due to oversupply conditions or declining effective demand. Allocations to real estate asset portfolios are dependent on contributing returns and perceived risks associated with acquisitions (Bruce, 1991). Portfolio Exit strategies There are many reasons why institutional real estate portfolio managers dispose of properties.

The new institutional imperative for disposition strategies of real estate portfolios is generated by pressures on management in the following areas: re-emphasis on core business, product and geography; reaction to poor performance of real estate portfolios; new risk-based capital standards imposed by banks and institutional equity investors; and rapidly declining property income and asset values.

Disposition strategies include: single asset management sales, portfolio auctions, pooled asset portfolio sales, bulk portfolio sales, securitized asset pooled asset sales, or UPREITing the portfolio into the public market (Buckley, 1994). 19 RESEARCH DESIGN I REAL ESTATE IN A CAPITAL MARKETS CONTEXT Introduction Apartment portfolio construction has been out of favor for some time due to concerns of overbuilding in some markets. We believe that long-term apartment fundamentals are solid and investors have overreacted to short-term market conditions.

Over the long run, apartments have provided investors with the highest risk-adjusted rates of return of any real estate asset class. Some apartment markets whose long-term returns have been heavily discounted due to excessive volatility may have been oversold by investors, providing opportunities for contrarian or riskseeking investors. Those apartment markets whose returns have been negative or flat for quite some time, reaching their cyclical bottom, could be poised for rapid income and capital appreciation as they move into the recovery phase of their cycle.

It is expected that these portfolios will see rapid income appreciation induced by a healthy national economy and capital appreciation spurred by large institutional (REIT and pension fund) capital inflows. These capital flows are attracted to apartment portfolios because of their high income returns and undervalued status in the capital markets compared to other competitive financial market assets (stocks and bonds).

Through the use of capital market analysis, we can identify which portfolios will continue to attract risk-averse, risk-neutral, and speculative capital over time. This section of the study identifies those portfolios (assets, real estate markets and real estate investment trusts) that have exhibited high risk-adjusted returns in the capital markets over time, and assumes that these portfolios will continue to attract capital flows from risk-averse investors. These portfolios are plotted within an efficient frontier context by expected return and risk (standard deviation).

This analysis examines historical relationships between risk and return and recommends portfolios based on high risk-adjusted returns, and those portfolios that appear to have reached their cyclical bottom and are poised for value increases. Investment portfolios analyzed in this study are: Competitive Capital Market Assets Competitive Real Estate Portfolios by Asset Class Competitive Real Estate Portfolios by Region Competitive Apartment Portfolios by Region Competitive Real Estate Portfolios in the Western Region Competitive Real Estate Portfolios by Western Regions Competitive Metropolitan Apartment

Portfolios in Western Region Competitive Apartment Real Estate Investment Trust Portfolios 20 This section of the report is divided into five sections: methodology, discussion of results, conclusions and recommendations, assumptions and appendices. • • • The Assumptions section defines the theoretical constraints for the capital market and efficient frontier models. The “Methodology” section introduces the procedures taken to arrive at the order of portfolios ranked by risk-adjusted return.

The “Discussion of Results” section elaborates on why these portfolios rank the way they do, and why they are positioned the way they are within an efficient frontier context. This section also identifies which portfolios are attractive to risk averse, risk neutral and risk seeking investors. The “Conclusions and Recommendations” section summarizes the findings and makes recommendations for future portfolio investment based on the results of the analysis and strategy of the investor. Lastly, this section briefly discusses future portfolio research.

The Appendix gives the efficient frontier graphs; statistical rules of thumb, diversification analysis and variance analysis, back-testing graphs and tables, qualitative factors, optimization and regression results, risk-adjusted return tables; total return tables; standard deviation tables; total return graphs; and return deviation graphs, by competitive portfolio (market); and definitions and data sources. • • Before discussing the results of the study we must make some assumptions. First, capital markets are efficient and capital flows move freely at no or low transaction costs.

Second, the majority of investors are risk-averse. Generally, most institutional investors are risk-averse, but they can also be considered risk neutral, risk seeking, speculative or contrarian depending on their yield requirements, investment horizon and risk tolerance. Third, total returns are normally distributed over time. Assumptions Efficient Capital Markets The capital markets are assumed to be efficient in modern portfolio theory because it consists of a large number of rational, profit-seeking and risk-averting investors.

They compete freely with each other in estimating the future value of individual assets and markets. Since any change affecting a given asset or market is quickly known it is therefore rapidly reflected in the price of the asset to which it relates. The capital market is said to be efficient because it quickly incorporates any new change or event affecting the value of the asset. It is assumed that capital markets are efficient in that prices adjust rapidly to the infusion of information and capital flows, and prices fully reflect all information regarding the asset. Markets are efficient in that: 1 • • • A large number of profit-maximizing participants are concerned with the analysis and valuation of the asset, and that these participants operate independently of each other. New information regarding assets comes to the market in a random fashion, announcements are generally independent of one another. Asset prices (intrinsic value) that prevail in the market at any time should be an unbiased reflection of all currently available information, including risk. Therefore, returns implicit in the price reflect the risk involved, so the expected return is consistent with risk.

Investors adjust asset prices rapidly to reflect the effect of new information. Although price adjustments are not always perfect, it is unbiased, and over and under adjustments average out over time. • Under these assumptions, a single asset or portfolio of assets is considered to be “efficient” if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return. Efficient Frontier The first step in the portfolio (market) selection process is to determine the risk-return opportunities available to the investor.

The efficient (minimum-variance) frontier is a graph of the lowest possible portfolio (asset or market) variance that can be attained for a given portfolio expected return. The efficient frontier is a graphic presentation of the pairing between expected returns and minimum-risk portfolios (assets or markets). The second step in the portfolio (market) selection process is to search for portfolios with the highest reward-to-variability ratio. The efficient frontier is that set of portfolios that has the maximum return for every given level of risk, or the minimum risk for every level of return.

The shape of the efficient frontier assumes for risky assets is generally such that one has to tolerate more and more risk to achieve higher returns. The slope of the efficient frontier decreases steadily as you move up the curve. This tendency implies that equal increments of added risk, as you move up the efficient frontier, will add progressively less of an increment in expected return (declining returns to scale). Capital Flows Capital allocators make investment decisions under uncertainty, therefore seek to achieve the best possible trade-off between risk and return.

The capital allocation decision is the choice between putting investment funds in safe but low return assets versus risky but higher-return assets. 22 Risk-free assets, such a T-Bills, are short-term in nature making them insensitive to interest rate fluctuations. An investor can lock in a short-term nominal return by buying a bill and holding it to maturity. The inflation uncertainty over the course of a few weeks, or even months, is negligible compared with the uncertainty of other risky investments. Institutional investors follow a top-down approach to capital allocation.

Since capital flows freely across markets, historical and new information is incorporated into asset prices instantaneously and their are no or low transaction costs, institutional investors can adjust their real estate portfolio positions relatively rapidly, therefore they are constantly adjusting their portfolios to minimize risk or maximize risk-adjusted returns. Under these assumptions capital flows are disciplined and will continue to flow to those assets or portfolios offering the highest long-term risk adjusted returns. Investing in a REIT that is diversified within a region can be considered a passive investment strategy.

Forces of supply and demand in large capital markets may make such a strategy a reasonable choice for many institutional investors; therefore, by developing a clear, well defined and communicated portfolio and risk management policy, and institutional real estate manager (REIT) can continue to attract institutional capital flows. Investor Preferences Most investors try to determine the best risk-return opportunities available in the market, try to avoid risk and demand a reward for engaging in risky investments. The reward is taken as a risk premium, an expected rate of return higher than that available on alternative risk-free investments.

Investors make personal trade-offs between risk and expected return, and is dependent on their welfare or utility function. The proper way to measure the risk of a portfolio is to assess the volatility of total returns over time. Investors determine where they want to be within the efficient frontier in terms of their utility function and attitude toward risk. They would then select a portfolio based on their risk preferences. No portfolio is dominated by any other portfolio, they all have different return and risk measures, and returns increase with risk.

Risk-averse investors penalize expected return on risky portfolios to account for risk, the greater the risk the larger the penalization. Depending on the investors’ utility function, higher welfare is achieved from higher expected returns and lower welfare is achieved from higher return volatility. The extent to which the variance of returns lowers investor welfare depends on the degree of risk aversion, the more risk-averse an investor is the larger the risky investment is penalized. • Speculators invest is assets with considerable business risk and expect a commensurate gain beyond the risk-free alternative.

Speculators invest in spite of the risk involved because they perceive a favorable risk-return trade-off. 23 • Risk-neutral investors judge risky prospects solely by their expected rates of return. The level of risk is irrelevant to the risk-neutral investor, meaning there is no penalization for risk, the risk-adjusted rate of return is simply its expected rate of return. The risk lover is an investor who is willing to gamble on an investment, adjusting the expected return upward to take into account the “fun” of confronting the prospect’s risk. •

Normality of Returns Modern portfolio theory, for the most part, assumes that asset returns are normally distributed, therefore, total returns on portfolio investments are assumed to be normally distributed over time. This is a convenient assumption because the normal distribution can be described completely by its mean and standard deviation, justifying mean-variance analysis. The argument has been that, even if individual asset returns are not exactly normal, the distribution of returns of a large portfolio will resemble a normal distribution quite closely.

This is how one can best describe the uncertainty of portfolio rates of return. The expected rate of return in this study is an equally (time) weighted average of returns, the weights being the probabilities. The characterization of risk is implied by the nature of the probability distribution of returns. The idea is to describe the likelihood and magnitudes of “surprises” (deviations from the mean) with as small a set of statistics as is needed for accuracy. Methodology The Capital Market or Efficient Frontier Analysis (EFA) consists of four separate but related phases.

Phase I: Phase II: Phase III: Phase IV: Portfolio Selection Calculate Expected Return and Standard Deviations Plot Portfolios by Expected Return and Standard Deviation Rank Portfolios by Risk-Adjusted Returns Note: For this study a portfolio is an asset class, an asset class by region or a real estate investment trust. • Rankings by relative performance is simply a sort in descending order of portfolios by riskadjusted returns. Risk-adjusted returns are portfolio expected or average returns over the sample time period divided by the standard deviation of total returns for this same time period.

Please refer to the Appendix and the notes in the risk-adjusted return tables for sample time periods. Caution: Short sample time periods may produce higher sampling errors. 24 • Risk-adjusted returns give the number of units of return for each given unit of risk for each portfolio. Risk- adjusted returns measure portfolios that have the maximum return for every unit of risk, or the minimum risk for every unit of return. This allows for comparison across portfolios after controlling for risk. Please refer to the riskadjusted return tables and total return graphs, in the Appendix for more details.

Risk is the variance or standard deviation of expected returns. It is a statistical measure of the dispersion of returns around the (mean) expected value; that is, a larger value for the variance or standard deviation indicates greater dispersion , all other factors being equal. The ideal is that the more dispersed the returns, the greater the uncertainty (risk) of those returns in any future period. Please refer to the riskadjusted return tables, sorted by standard deviation, and total return deviation graphs in the Appendix for more details. The total return deviation graphs illustrate the degree of volatility in the portfolio’s total return, the degree of the portfolio’s real estate cycle trough or peak, and allows for identification of where the portfolio is within its current real estate cycle. • • The Efficient Frontier plots are graphical illustrations of where each market is located within a competitive capital market context. 25 I n s titu tio n a l R e a l E s ta te C a p ita l A llo c a tio n L in e M o v e m e n ts A lo n g th e E ffic ie n t F r o n tie r

D ir e c t R e a l E s t a t e D e v e lo p m e n t LEVERAGE C a p i t a l A llo c a t io n L in e ( C A L ) 1 0 0 % H ig h R is k /R e t u r n P o r t f o lio M arket B a sk et L o w e r R is k /R e t u r n R e a l E sta te In v e stm e n ts L E N D IN G A p a rtm en t L o a n O r i g in a t io n H ig h e r R e t u r n /R is k R e a l E sta te In v e stm e n ts 100% L ow R e t u r n /R is k P o r t f o lio ?* ? Mean Expected Return E (r) High Return Low Risk Portfolios Target Portfolios Risk-Averse Investors High Return High Risk Portfolios

Risk-Averse and Risk-Neutral Investors Speculators Low Return Low Risk Portfolios Contrarian Investors Opportunistic Investors Low Return High Risk Portfolios Risk Seeker or Lover Gamblers Standard Deviation ? 26 • According to capital market theory, portfolios exhibiting high long-term relationships between risk and return are located in the upper right-hand corner of the graph, and portfolios exhibiting low long-term relationships between risk and return are located in the lower left-hand corner of the graph.

Target portfolios for risk-averse investors are those portfolios that exhibit high stable long-term returns with low standard deviations. These portfolios are located in the upper left-hand corner of the graph. • Some risk-averse (institutional) investors would be willing to accept lower returns for lower risk. These portfolios are located in the lower left-hand corner of the graph. • • Target portfolios for conterarian or opportunistic investors are those that have exhibited low total returns and low risks. These investors are anticipating higher future returns at lower risk levels. Risk seeking investors, or gamblers, are willing to invest in portfolios with high risk and low returns in anticipation of the possibility of achieving high returns in the future to compensate for high risk levels. These portfolios are located in the lower right-hand corner of the graph. Some opportunistic investors would be willing to accept lower returns for higher risk if they felt the portfolio was under valued in the capital markets, leading to arbitrage opportunities. • Please refer to the efficient frontier graphs in the Appendix for more details.

Data sources for portfolio total returns and standard deviations came from the National Council of Real Estate Investment Fiduciaries (NCREIF), Koll/National Real Estate Index and Dean Witter Reynolds Investment Banking Unit. • The NCREIF real estate indexes are appraisal based and are a representative sample of institutional real estate holdings by asset class and region. Total return and standard deviation information was compiled from quarterly return statistics. Total returns include income return and capital appreciation.

The Koll/National Real Estate Index is a biannual/quarterly survey based on a sample of properties by asset class and metro area. Total returns and standard deviations were derived by adding together the biannual/quarterly percentage change in sales price per square foot with the biannual/quarterly capitalization rate to arrive at a total return figure. • 27 • Dean Witter Reynolds Investment Banking Unit provided total dividend yields and percent change in stock prices for the competitive REITs to arrive at a total return figure on a quarterly basis.

NATIONAL COUNCIL OF REAL ESTATE INVESTMENT FIDUCIARIES (NCREIF) GEOGRAPHIC REGIONS East Northeast Maine New Hampshire Vermont Massachusetts Rhode Island Connecticut New York New Jersey Pennsylvania Mideast Delaware Maryland Washington D. C. West Virginia Virginia North Carolina South Carolina Kentucky Midwest East North Central Wisconsin Michigan Ohio Indiana Illinois West North Central Minnesota Iowa

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