Leverage and Real Estate Investment in Mixed-Asset Portfolios

Executive Summary. Academics examining real estate's potential to improve the efficiency of mixed-asset portfolios usually view the situation from the perspective of the debt-free equity investor. This study investigates the implications for portfolio performance of holding leveraged real estate. Of particular interest is the effect of including leveraged real estate in portfolios held by nontaxable institutions. To investigate these effects, a bootstrap estimate with a Markowitz mean-variance analysis is used to generate efficient portfolio frontiers from annual investment performance data covering both securities and real estate. The efficient frontiers represent different assumed opportunity sets which vary depending on the inclusion of debt-free real estate, leveraged real estate and real estate tax effects. All the appraisal-based real estate data used in this study were adjusted for “smoothing”.Overall, the results are consistent with theoretical expectations. Beginning with a securities-only opportunity set (stocks, corporate bonds and t-bills), adding debt-free real estate produced higher portfolio efficiency (lower risk) for all investors except those with the very lowest risk preference. For nontaxable investors, leveraging the real estate caused a decline in mixed-asset portfolio efficiency. However, for taxable investors, leveraging the real estate improved portfolio performance.