Intelligent Investment

A Harry Markowitz tribute: Modern Portfolio Theory and the case for U.S. real estate

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August 1, 2023

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The headlines say it's time to divest U.S. commercial real estate. Harry Markowitz would probably beg to differ.

Markowitz, a Nobel-Prize-winning economist who passed away in June at age 95, popularized the Modern Portfolio Theory (MPT) as a strategy for producing the best risk-adjusted returns.

Applying MPT to commercial real estate, we present a scatterplot of the average returns and standard deviations of differently weighted portfolios across the U.S., APAC and Europe. This shows that the optimal commercial real estate portfolio would include more than 50% exposure to U.S. real estate with the balance favoring APAC. This is because APAC has generated notably higher returns than Europe, even though those returns are highly correlated (0.75 correlation) and have very similar standard deviations. The U.S., on the other hand, has produced long-run returns slightly lower than APAC but at a notably lower standard deviation. Further, the U.S.’s is much less correlated with Europe or APAC -- about 0.33 and 0.31, respectively.

With an ability to aggregate returns, risk and correlations into a single analysis, MPT makes the case that U.S. should still comprise the dominant share of any diversified global real estate portfolio. Of course, this analysis takes a rearview mirror view of returns and does not account for today’s market circumstances, particularly the challenges facing office assets. However, rising interest rates and strained credit conditions are not new, and, even considering today's market dynamics, a long-term investment horizon suggests investors may be overcorrecting away from U.S. real estate.

Markowitz's theory makes a sound argument for the role of U.S. real estate in a balanced global portfolio and offers an antidote to today’s widespread doom-and-gloom.

Figure 1: Efficient Frontier - Portfolio of U.S., European, APAC Commercial Real Estate

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*based on 18 years of GREFI (Global Real Estate Fund Index) quarterly returns by region.
Source: GREFI, CBRE Econometric Advisors

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