Journal of Real Estate Finance and Economics, 29:3, 295±320, 2004
# 2004 Kluwer Academic Publishers. Manufactured in The Netherlands.
The Role of Real Estate in an Institutional Investor's
GREGORY H. CHUN
Kimpo College, Kyoung-do, 415-870, Korea
Department of Finance, University of Iowa, Department of Finance, Suite 252, Iowa City, IA 52242, U.S.A.
JAMES D. SHILLING
University of Wisconsin-Madison, Department of Real Estate and Urban Economics, 975 University Avenue,
Madison, WI 53705, U.S.A.
Many papers have recently pointed out that institutional investors allocate only a very small fraction of their
portfolio to real estate, much smaller than theory would dictate. This raises the question, are institutional investors
underinvested in real estate equities? Or do we simply have the wrong priors? This paper is an attempt to provide
some new insights into this asset allocation paradox. The key conclusions of the paper are several: First, unlike
other assets, it would appear that real estate, and real estate diversi®cation, pays off at the very time when the
bene®ts are most needed, that is, when consumption growth opportunities are low. Second, real estate returns are
predictable. In fact, the amount of predictability in real estate returns appears to be about the same as in stock
returns. Third, real estate performs well in an asset-liability framework. Fourth, the chance of experiencing a large
loss on real estate over a long horizon is quite small. We also report here that private sector commercial real estate
investments represent between 6 and 12 percent of investable wealth in the United States. Thus, it follows (if one
believes the capital asset pricing model) that if institutional investors were to invest more in real estate (up to 12
percent of their assets), they should be able to eliminate nonmarket or unique risk. All of this leaves us a bit
dumbfounded as to why institutional investors hold only between 2 and 3 percent of their assets in real estate.
Key Words: portfolio choice, asset pricing, pension funds
Most people would argue that institutional investors should invest between 15 and 20
percent (or higher) of their assets in real estate. Yet all the available data on ownership
of real estate show that institutional investors hold between 2 and 3 percent of their assets
in real estate. This raises a very important question, which case is true? Are institutional
investors underinvested in real estate equities? Or do we simply have the wrong