Understanding Real Estate Option

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Diversification with real estate

The expression "Don’t put all your eggs in one basket" has been a guiding principle for a long time. Modern Portfolio Theory, which was popularized by Harry M. Markowitz in 1952 for which he won the Nobel Price in 1990, combines investment diversification principles with quantifying risk and return. From this theory, one can achieve a superior return and less risk by combining different assets.

The table below summarizes means, standard deviations and correlations for 3 major assets: S&P 500 index, Long-Term Government Bonds, and Private Real Estate.
Source: Ibboston Asscociates (Morningstar)

  S&P 500 LTG Bonds Private Real Estate
Mean 12.7% 9.7% 9.9%
SD 17.5% 11.8% 9.0%
S&P 500 100.0% 27.2% 16.6%
LTG Bonds   100.0% -21.0%
Private Real Estate     100.0%

Diversification effect is greater when the assets are less correlated. From the data above, one can create a combine portfolio of 50% bonds and 50% real estate assets and the new portfolio exhibits the same mean while decreases deviation by 44% as shown in the table below.

Returns Bonds Real Estate  Portfolio (50/50)
Mean 9.7% 9.9% 9.8%
Standard Deviation 11.8% 9.0% 6.6%

The above mentioned portfolio shows that diversification in real estate assets reduces financial risk, as measured by volatility in prices. Specifically, the 6.6% volatility of the resulting portfolio is lower than the individual volatilities of the bonds and real estate assets, while the return remains approximately the same at 9.8%.

Please study Real Estate Market Diversification Analysis across many geographic areaa.

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