How Many Properties are really Needed for a Diversified Family Office Real Estate Portfolio?
It has been shown that 15 to 20 randomly selected stocks can eliminate most of what is referred to as “unsystematic” risk in a stock portfolio. Unsystematic risk is unique to a specific property which can be eliminated through diversification.What remains is the “systematic risk” that impacts all stocks and is measured by the well known “beta.” The question is whether a similar number of randomly selected real estate investments can also reduce most of the unsystematic risk. Properties are real as opposed to financial assets and are lumpier than stocks and each property is unique. Does that make it harder to diversify? We will see.
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Supporting Data
To show this, we did an experiment using data from the National Council of Real Estate Investment Fiduciaries which has a database of about 10,000 properties around the US consisting of all the major property types (office, industrial, retail, apartment and hotel). We created portfolios of different sizes by drawing properties randomly from the NCREIF database and calculated the standard deviation over a specified time period.
Supporting Data
To show this, we did an experiment using data from the National Council of Real Estate Investment Fiduciaries which has a database of about 10,000 properties around the US consisting of all the major property types (office, industrial, retail, apartment and hotel). We created portfolios of different sizes by drawing properties randomly from the NCREIF database and calculated the standard deviation over a specified time period.
Standard Deviation
In addition to the correlation between properties, the standard deviation of each property enters into the calculus for reducing risk. Lets assume a few simplifying assumptions such as the correlation between the returns for all properties is the same and the standard deviation of the returns for all properties is the same.
Correlation Coefficient
The correlation coefficient is a key driver of diversification.The average correlation coefficient between different properties tends to be around 0.60 which suggests there are diversification benefits of combining properties in a portfolio.
