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Article Excerpt
We use constrained cross-sectional regressions to disentangle the effects of various factors on international real estate security returns. Besides a common factor, pure country, property type, size and value/growth factors are considered. The value/growth measure that is used in this paper provides for each security the relative importance of the value and growth components, rather than a binary classification. The value/growth factor is found to be volatile and to have a substantial effect on returns over the period February 1990-April 2003. Country factors are the dominant factors, and size is shown to have a negative impact on returns. Statistical factors derived by means of cluster analysis explain about one third of specific returns on international real estate securities. The implication for portfolio managers is that failing to recognize the importance of the various factors leads to the portfolio being exposed to systematic risk.
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For stock portfolio managers executing a top-down approach, it is crucial to decide whether the strategy will be based primarily on countries, sectors, industries or some other factor such as size or value/growth. Diversification by sectors is growing in importance, but geographical allocation remains important despite the globalization of international financial markets. In this context, real estate securities are considered as one industry, but they are too often discarded from the strategic portfolio allocation. This is surprising given that real estate securities have been shown to be effective diversifiers of common stock portfolios (Liang, Chasrath and McIntosh 1996, Gordon, Canter and Webb 1998). Moreover, the correlation of U.S. REITs with common stocks has been declining (Ghosh, Miles and Sirmans 1996, Brounen 2003). Also, the market value of publicly traded real estate companies has grown substantially in recent years, with an estimated figure of US$340 billion as of April 2003.
Extensive research has been conducted since the 1970s on the benefits of international diversification for stock portfolios. There is also more recent evidence on the benefits of international diversification for portfolios of both direct and indirect real estate investments. The cross-country correlations are usually lower for real estate investments than for common stocks. There is evidence, however, of an international real estate factor (Ling and Naranjo 2002) and also of continental factors (Eichholtz et al. 1998). Country-specific factors remain important, however, which explains the diversification benefits. Eichholtz and Huisman (2001) show, for instance, that country dummy variables are usually significant in a model that also includes beta, size and interest rate variables.
When constructing a portfolio of publicly traded real estate stocks, much emphasis is placed on the analysis of the correlation coefficients across countries (or across continents). We argue that while these correlations are useful, it would be important to disentangle the effects of various factors on real estate company returns and hence on cross-country correlation coefficients. The aim of this paper is to calculate the pure effects of various factors on international real estate security returns. For this purpose, we use real estate security returns for the 10 countries with the highest market capitalization for the period from February 1990 to April 2003, and we extract such pure effects using a cross-sectional factor estimation technique. The factors that we consider are the following: a common factor affecting all securities, the well-known size effect first analyzed by Banz (1981), the value/growth factor of Fama and French (1992), the main property type in which the company invests and the country of origin of the security. Cluster analysis is used on the residuals of this analysis to ascertain whether an additional factor can be extracted once the effect of the common and pure factors has been eliminated. The relative importance of each pure factor is highlighted. Such an analysis is of great importance as changes in cross-country correlation coefficients may be due to changes in any of the other factors. By extracting the influence of other factors on cross-country correlations, it is possible to ascertain the true potential of international real estate portfolio diversification.
The pure factor approach developed in this paper has important implications for portfolio management. The active portfolio manager will have to decide according to which factor(s) he or she wants to make a bet. If countries with positive expected returns are selected, for instance, then he or she has to make sure that this strategy is neutral with respect to all other factors influencing returns (property type, growth and size). For instance, if it is decided to over-weight Japan, it should be recognized that the growth exposure of this country is substantially larger than that of the world and that the Japan bet also results in a bet being made on growth.
The paper is organized as follows. In the following section, we discuss related work on international real estate diversification. Next, we present our data, while the method that we use to assess the risk of real estate portfolios is discussed in the following section. We then present our results. The last section contains some concluding remarks.
International Real Estate Diversification
The issue of international diversification of stock portfolios has received substantial attention in the financial economics literature since the seminal work by Solnik (1974). The general conclusion is that widening the investment spectrum to nondomestic stocks permits an increase in risk-adjusted returns. Moreover, geographical diversification has been shown to be more effective than diversification by industry (Heston and Rouwenhorst 1994, 1995). Recent work has shown that the world economy is becoming increasingly global, with international stock markets becoming more and more correlated with each other (Solnik and Roulet 1999). In such a context, industrial factors have gained in importance (Cavaglia, Brightman and Aked 2000, Hamelink, Harasty and Hillion 2001).
Far less attention has been given to this issue in the real estate literature due to the relative lack of quality international data on the performance of real estate. Case, Goetzmann and Wachter (1997) find that returns to commercial real estate tend to move together (although not perfectly) across property types within each country and that international diversification within three segments of the real estate market (industrial, office and retail) would have been beneficial over the period 1986-1994. Quan and Titman (1997) report that U.S. real estate returns are less highly correlated with real estate returns in other countries than is the case of U.S. stocks with international stocks, suggesting significant benefits from international real estate diversification (see also Newell and Webb 1996). Goetzmann and Wachter (2001) also find that cross-border real estate diversification is useful. They show that cross-border correlations are due in part to common exposure to fluctuations in the global economy, but that country-specific GDP changes help explain more of the variation in real estate returns than the global factor. This would indicate a stronger impact of local factors than has been reported for common stocks (Beckers, Connor and Curds 1996). Goetzmann and Wachter (2001) report that international real estate diversification is more beneficial than international stock diversification for industrial real estate but not for other property types. Several studies have also looked at whether international real estate portfolios should be hedged against currency fluctuations (see, e.g., Ziobrowski, Ziobrowski and Rosenberg 1997). The results concerning the usefulness of hedging are mixed. When it is decided to hedge, then currency swaps have been shown to be best suited given the long-term nature of real estate investments.
Securitized real estate has been shown to be quite highly correlated with common stocks on an international basis (Eichholtz 1997), although there is evidence for U.S. REITs and also for real estate securities in other countries that this correlation has been declining (Ghosh, Miles and Sirmans 1996, Brounen 2003). Also, and as is the case for direct real estate (Goetzmann and Wachter 2001), there is evidence of a worldwide factor in international indirect real estate returns (Ling and Naranjo 2002). The latter authors also find that a country-specific factor is highly significant, which would suggest that international diversification is useful when constructing portfolios of real estate securities. In a study of the excess returns on securitized real estate in six countries, Eichholtz and Huisman (2001) find that country dummy variables are significant in almost all instances. They also show that the level of interest rates...
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