Real estate portfolio construction and estimation risk

Purpose - The use of modern portfolio theory (MPT) in the construction real estate portfolios has two serious limitations when used in anex anteframework: the intertemporal instability of the portfolio weights; and the sharp deterioration in performance of the optimal portfolios outside the sample period used to estimate asset mean returns. Both problems can be traced to wide fluctuations in sample means. Aims to prove that the use of a procedure that ignores the estimation risk due to the uncertain in mean returns is likely to produce sub‐optimal results in subsequent periods. Design/methodology/approach - This study extends previousex ante‐based studies by evaluatingex postoptimal portfolio allocations in subsequent test periods by using methods that have been proposed to reduce the effect of measurement error on optimal portfolio allocations. Findings - While techniques designed to handle estimation risk in capital market studies have yielded promising results, they are not completely successful in improving out‐of‐sample performance in this case. It is hypothesised that such results are due to the cyclical nature of property and that the contrarian and mean‐reversion effects picked up in studies of stocks and bonds are not captured when an asset such as direct property is examined. This conclusion is also supported by the strong performance of the tangency portfolios, and in particular the classical unadjusted Sharpe portfolio, over the shorter horizons, which would be consistent with a cyclical momentum effect. Originality/value - The results suggest that the consideration of the issue of estimation risk is crucial in the use of MPT in developing a successful real estate portfolio strategy.