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  1. 1. REITs and Portfolio Diversification
  2. 2. <ul><li>Capital Asset Pricing Models (CAPM) </li></ul><ul><ul><li>A. Risk compensation </li></ul></ul><ul><ul><ul><li>1. unique vs. systematic risk </li></ul></ul></ul><ul><ul><ul><li>2. idiosyncratic vs. nondiversifiable </li></ul></ul></ul><ul><ul><li>B. Appropriate market portfolio </li></ul></ul><ul><ul><ul><li>1. stock and/or bond markets typically used </li></ul></ul></ul><ul><ul><ul><li>2. real estate estimated to comprise 50% of US stock of wealth vs 20% for stocks </li></ul></ul></ul><ul><ul><li>stock market risk may be diversifiable </li></ul></ul>
  3. 3. <ul><ul><li>C. market risk and beta </li></ul></ul><ul><ul><ul><li>1. R f = risk-free return </li></ul></ul></ul><ul><ul><ul><li>2. R m = market return </li></ul></ul></ul><ul><ul><ul><li>3. R re = real estate return </li></ul></ul></ul>
  4. 4. Definitions <ul><li>Expected Portfolio Return (2 stocks): </li></ul><ul><ul><li>Weighted average of each stock’s expected return. </li></ul></ul>
  5. 5. Definitions <ul><li>Portfolio Variance: </li></ul><ul><ul><li>sum of share-weighted averages of the variances of stock returns plus the covariances among stock returns. </li></ul></ul>
  6. 6. Definitions <ul><li>Covariance: </li></ul><ul><ul><li>absolute measure of the extent to which 2 stocks move together over time. </li></ul></ul><ul><ul><ul><li>Positive Covariance - 2 assets move together </li></ul></ul></ul><ul><ul><ul><li>Negative Covariance - 2 assets move apart </li></ul></ul></ul><ul><ul><ul><li>Gives contribution of stock to overall portfolio risk </li></ul></ul></ul>
  7. 7. Definitions <ul><li>Correlation: </li></ul><ul><ul><li>relative measure of the extent to which 2 stocks move together. </li></ul></ul><ul><ul><ul><li>Perfectly Positive = +1 </li></ul></ul></ul><ul><ul><ul><li>Perfectly Negative = -1 </li></ul></ul></ul>
  8. 8. Definitions <ul><li>Portfolio Variance – reprise </li></ul>
  9. 9. Portfolio Diversification <ul><li>Now consider the “market” portfolio. </li></ul><ul><ul><li>How many stocks are in the market? </li></ul></ul><ul><ul><ul><li>Assume market composed of “N” stocks. </li></ul></ul></ul>
  10. 10. Portfolio Diversification <ul><li>Out of the “N” stocks in the market, let’s assume that #2 represents the return on REITs. </li></ul><ul><li>How do you measure the REIT contribution to the overall portfolio risk? </li></ul><ul><ul><li>Answer: Covariance </li></ul></ul>
  11. 11. Portfolio Diversification <ul><li>Let’s look at the “N” stock market variance/covariance matrix </li></ul><ul><ul><li>Gives contribution of each stock to portfolio risk. </li></ul></ul>
  12. 12. Portfolio Diversification <ul><li>The Marginal Risk of REITs = </li></ul><ul><ul><li>Covariance of REIT and market divided by overall market risk. </li></ul></ul>
  13. 13. Portfolio Diversification <ul><li>Note that: </li></ul>
  14. 14. Portfolio Diversification <ul><li>Thus: </li></ul><ul><li>Note: </li></ul>
  15. 15. Portfolio Diversification <ul><li>So what’s the point? </li></ul><ul><ul><li>Compound Annual Returns (1981-2001): </li></ul></ul><ul><ul><ul><li>REITs  10.79% </li></ul></ul></ul><ul><ul><ul><li>S&P 500  11.59% </li></ul></ul></ul><ul><ul><ul><li>Russell 2000  11.44% </li></ul></ul></ul><ul><ul><ul><li>NASDAQ  11.18% </li></ul></ul></ul>
  16. 16. Portfolio Diversification <ul><li>So what’s the point? </li></ul><ul><ul><li>20-year Standard Deviation of Annual Returns (1981-2001) </li></ul></ul><ul><ul><ul><li>REITs  16.5% </li></ul></ul></ul><ul><ul><ul><li>S&P  19% </li></ul></ul></ul><ul><ul><ul><li>NASDAQ  29% </li></ul></ul></ul>
  17. 17. Portfolio Diversification <ul><li>So, what’s the point? </li></ul><ul><ul><li>Correlation: </li></ul></ul><ul><ul><ul><li>REIT & S&P500  0.25 </li></ul></ul></ul><ul><ul><ul><li>REIT & NASDAQ  0.13 </li></ul></ul></ul><ul><ul><ul><li>REIT & Russell 2000  0.40 </li></ul></ul></ul>
  18. 18. Portfolio Diversification <ul><li>So, what’s the point? </li></ul><ul><li>REITs provide diversification benefits to portfolios. </li></ul>