Optimal allocation to real estate incorporating illiquidity risk

Shaun A Bond (), Soosung Hwang and Kimberley Richards
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Shaun A Bond: University of Cambridge
Soosung Hwang: University of Cambridge
Kimberley Richards: University of Cambridge

Journal of Asset Management, 2006, vol. 7, issue 1, No 2, 2-16

Abstract: Abstract This paper considers how the illiquidity risk associated with the uncertain marketing period of a commercial property affects the allocation to real estate assets in a mixed-asset portfolio. Using the model of marketing period risk discussed by Bond et al. (‘Marketing Period Risk in a Portfolio Context: Theory and Empirical Estimates from the UK Commercial Real Estate Market’, mimeo, Department of Land Economy, University of Cambridge, 2005) and UK asset return data, the study finds that the allocations to real estate in a portfolio with a short holding period (one year) fall dramatically following the incorporation of the illiquidity risk into the analysis. For longer holding period portfolios (five years), however, the impact of the illiquidity risk on portfolio allocation is less significant. The results do not explain the large discrepancy between observed portfolio allocations to real estate and the allocations suggested from standard mean-variance models. Illiquidity risk appears to be a contributing factor, but it is not the main driver of low actual allocations to real estate in UK pension funds.

Keywords: illiquidity risk; commercial real estate; asset allocation (search for similar items in EconPapers)
Date: 2006
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DOI: 10.1057/palgrave.jam.2240197

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