Real estate, risk, return and optimal portfolios

Abstract

This master's thesis contributes to the understanding of optimal portfolio diversification by examining the position of residential real estate. By incorporating the principles of Modern Portfolio Theory, including Markowitz’s portfolio theory, CAPM, and FF3, the thesis provides an in-depth analysis of risk, return, and diversification possibilities. Moreover, by considering the lasting effects of the Global Financial Crisis, the thesis sheds light on the interplay between risk, rare events, and real estate. The results reveal that the real estate sector exhibits relative stability when looking at systematic risk in both asset pricing models, although it is prone to rare extreme events increasing risk significantly. The risk-return estimates are further compared with the results from creating optimal portfolios. The optimal portfolio position of real estate is ambiguous because of the GFC. However, it is clearly beaten by sectors such as consumer staples and healthcare, being sectors with low risk and higher expected returns than real estate. At the same time, riskier sectors like consumer discretionary are also chosen over real estate, as they have better risk-return relationships. The analysis also finds that sectors with high relative volatility maintain the same relative position when considering systematic risk.