Content area
Full text
Executive Summary.
How many markets does it take to form a geographically well-diversified portfolio? Using a simulated approach, this study investigates the effectiveness of geographic diversification across the metropolitan areas in the United States. Four diversification schemes, the "Mixed MSA," "Large MSA Only," "Simultaneous," and "Large MSA by Property Type," are analyzed. The effectiveness of diversification is measured by the proportional portfolio risk reduction from the risk of single market. The findings suggest that: (1) it takes a large number of markets to eliminate most of nonsystematic risk in portfolios; (2) diversifying across large MSAs only is much less effective than across all MSAs; and (3) different types of properties exhibit very different risk reduction capability. The study raises the question as to how well-diversified are current institutional portfolios.
Geographic diversification is considered as an important portfolio strategy by most real estate investors. In an early survey of the investment practice of real estate investment trusts (REITs), Webb and McIntosh (1986) reported that, among investors who make systematic efforts to diversify their holdings, over 90% of them consider varying the geographic locations of properties the most popular method of diversification. In a more recent survey among pension fund real estate holdings, Worzala and Bajtesmit (1997) indicated that 73% of the managers consider geographic diversification at the regional levels, and 23.9% of these managers consider diversification at the metropolitan area level in their asset allocation process. While the evidence seems compelling that investors do attempt to diversify across geographic locations, their choices seem to be limited to a few so-called "core locations." Shilton and Stainley (1995) surveyed the NCREIF property database and found that institutional real estate investments are highly concentrated in large counties and/or metropolitan areas. Their findings indicate that about 30% of NCREIF properties are located in the seven largest counties, 45% in the largest fifteen counties, and nearly 60% of all investments are in the largest thirty counties, which represent twenty-six distinct metropolitan areas. Given there are over 320 metropolitan areas and more than 3,000 counties in the United States, such high concentration of institutional real estate holdings raises questions as to the effectiveness and appropriateness of institutional investment strategies.
For example, are those institutional portfolios well diversified? How much risk is...