Real Estate Alpha

CAPM / Alpha Theory 22 Jun 2009

In the pantheon of inefficient markets, one might expect commercial real estate to shine above all others.  After all, buying and selling real estate (actual real estate, not REITs), can incur significant transaction costs, the market for real estate is heterogeneous and there is no single real estate marketplace to provide efficient  pricing.

So does it follow that the management of commercial real estate investments offer up some juicy alpha opportunities?  That’s the question posed in a study by Shaun Bond of the University of Cincinnati and real estate consultant Paul Mitchell called “Alpha and Persistence in Real Estate Fund Performance”.

While other research has addresses the performance of real estate-focused mutual funds, this study uses multi-factor analysis to examine the alpha generated by large institutional investors in commercial property in the UK (pensions, insurance companies and the like).  In other words, Bond and Mitchell apply techniques that readers will find quite familiar.


One of the hallmarks of an alpha producing fund is return persistence – serial positive (or negative) returns that chance alone could not have produced.  A top quartile manager that remains in the top quartile for successive periods is said to be persistent.

But when Bond and Mitchell examine top quartile managers, they find that persistence seems to be dependent on the time frame examined.  For example, top performing managers in 1992 fell back to the mean immediately and by 1993 had rejoined bottom quartile managers.

But if you start the clock in 1997, things look a little different.  That year’s top performers stayed in the top quartile for several years before falling back to Earth.

Were the top performing managers of 1992 less skilled than those of 1997?  Probably not.  It seems more likely (to us) that some underlying factor propelled the 1992 top performers into the winners’ circle and that this factor reversed itself a year later.  By contrast, whatever factor put 1997’s winners on top may have had more longevity.  Such is the challenge of dealing with total performance data and not alpha itself.

Obviously, Bond and Mitchell were thinking the same thing. So they ran a multifactor regression to isolate the alpha produced by each manager.  Unlike return persistence, which can be influenced by alternative betas, alpha isolates true skill (and/or market inefficiencies).

Examining alpha over a ten year horizon, Bond and Mitchell find “there is some evidence that the general ordering of the initial quartiles is maintained.”

As you can see from the chart below, the top quartile in alpha generation during the first 10 year period (1987-1996) actually produced as much alpha per annum in the second 10 year period (1997-2006).

While the evidence supporting real estate alpha isn’t overwhelming, the authors still conclude and sectors come and go, but that skill and market inefficiencies may actually persist:

“…over the ten year sample, the alpha of a fund persists but that of raw performance does not… performance from good sector allocations cannot be sustained in the longer term.”

Overall, the duo isn’t overly impressed with the ability of real estate managers to produce true alpha – particularly given the alleged inefficiencies in the real estate market.  But as students of such studies are aware, precious few find much return persistence.  So this one is quite notable.

Post Script

Although the authors strip out several exogenous return drivers in their calculation of alpha, they maintain that real estate alpha remains (negatively) correlated to the economic cycle.

“There is some evidence to suggest that manager performance, as measured by alpha, is counter-cyclical. Alpha is higher during the boom periods of 1987-91 and 2002-2006. It is lowest for the period covering the early 1990s (i.e. 1992-96).”

Remember, this comes after the effect of the “boom times” themselves has been accounted for.  So it suggests that boom time may herald an inefficient market for commercial real estate – a likelihood that may sound familiar to those who invested during real estate bubbles.

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