Is Residential Real Estate a Viable Asset Class for Institutional Investors?

Abstract

The advent of futures contracts on residential housing indices has enabled the creation of synthetic investment positions in residential property, an asset class previously unattainable for institutional investors. To determine whether institutional investors have an incentive to utilize this method to invest in residential real estate, I examine the investment characteristics of the S&P/Case-Shiller Composite Home Price Index over the period 1987-2006. These investment characteristics will determine whether the futures contracts gain usage amongst investors and therefore, at least in part, whether these derivative contracts are successful in the long term. The results show that residential real estate is a low risk/low return type of investment, with risk adjusted performance lower than that of commercial real estate, but higher than most other asset classes. Residential real estate exhibits negative correlations with all other asset classes, making it excellent for diversification purposes. Within mean-variance efficient portfolios, residential property has large weightings in conservative up to mid-risk tolerance portfolios. More aggressive investors would not optimally invest in residential, although they would have a significant weighting on commercial property. However, if considered within an Asset Liability Management framework for a defined benefit pension plan, residential real estate plays little role in the optimal portfolio for any risk tolerance, although commercial real estate does. Overall, residential real estate has investment characteristics quite distinct from the commercial real estate in which institutions have traditionally invested, although the final weight in an optimal portfolio depends upon the objective and risk tolerance of the investor.