WHAT’S IN A NUMBER?
HOW TO ACHIEVE THE OPTIMUM PORTFOLIO SIZE
Diversification is a broad state which all investors rightly aspire to across
the asset classes, including real estate. However, the simplicity of the concept
belies the complications of achieving it: for example, how many assets does
an investor actually need to buy to be diversified? The answer does not
only determine the size of private real estate portfolios, but also the more
fundamental decision of how to invest in private real estate. This could range
from smaller amounts of capital for a stake in a fund-of-funds to a sizable
equity commitment for a separate account.
This research paper seeks to answer the question for the optimum number of assets. We
are not the first to attempt to quantify this but we have approached the question from a
number of new practical angles. We look across several countries, and we study whether
the answer varies across crisis or recovery phases. We also explore the difference if
portfolios are dominated by a few large assets, and look at the situation for an investor
who is risk-averse and wants to reduce the maximum risk it could face. We conclude by
providing estimates of dollar amounts for portfolios to give sufficient diversification.
Building a portfolio reduces the aggregate return volatility, but incremental diversification
benefits decline with every additional asset. Our research shows that if an investor wants
to achieve a 90% reduction of the possible risk reduction, then it should look to invest in
11-18 assets, depending on the region. For an 85% reduction, this number is 8-11 while a
95% reduction would require 21-35 assets. If portfolios consist of assets of rather different
sizes, more properties will be needed to reach the same reduction of specific risk.
No. of assets
Reduction of specific risk (%)
21-35
11-18
8-11
95%
90%
85%
Our results suggest that the optimal number is similar for crisis and recovery periods,
although in a period of downward market movements the total risk reduction will be
smaller but nevertheless still present. At a certain level, depending on region and risk
appetite, there is little to gain from a diversification perspective by adding further assets,
particularly as this will require more management and reduces focus.
Enlarging a portfolio for the sake of it is not enough for risk diversification. It is the
selection of the right assets which remains crucial in private real estate markets. Adding
one bad asset to an existing portfolio can undermine any diversification benefits. Our
research work in this area sets out the parameters for the average diversification benefits,
but it is smart portfolio construction and local market knowledge that can improve on this.
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©2015 CBRE GLOBAL INVESTORS, AMSTERDAM
OCTOBER 2015
AUTHORS
Marcel Theebe, PhD
Director of Research Analytics
T +31 20 202 2301
E marcel.theebe@
cbreglobalinvestors.com
Maarten Jennen, PhD
Director of Investment Solutions
T +31 20 202 2339
E maarten.jennen@
cbreglobalinvestors.com
GLOBAL SEPARATE ACCOUNTS
Pieter Roozenboom
Head of Global Separate
Accounts
T +31 20 202 2304
E pieter.roozenboom@
cbreglobalinvestors.com
FIGURE 1 RISK REDUCTION AS FUNCTION OF PORTFOLIO SIZE
How much of the total risk remains as the
portfolio grows?
How much of the specific risk is diversified away if
the portfolio grows?
PERCENTAGE
PERCENTAGE
100
100
90
80
95
70
60
90
50
40
85
NUMBER 0
OF ASSETS
30
20
10
NUMBER 0
OF ASSETS
10
20
30
40
50
USA
Netherlands
EMEA Other
USA
Netherlands
EMEA Other
UK
Sweden
All
UK
Sweden
All
60
BASED ON RETURNS FOR THE PERIOD 2009-2012; ASSETS ARE ASSUMED TO BE OF EQUAL SIZE.
HOW WE DERIVED OUR ANSWERS
Whereas previous studies tended to look at the UK or US only,
this research was based on a portfolio of 1379 properties
managed by our company in the US and across Europe.
We focus on diversification by reducing asset specific risk. When
many properties are combined, asset specific risks tend to be
cancelled out such that the portfolio risk resembles that of the
entire real estate market. Market risk can only be diversified
away with investments in other types of markets.
The properties were selected based on return availability. Most
of our analyses are based on years 2009 to 2012, to allow for
a sample as large as possible; some of our sub analyses also
looked at returns achieved since 2006 to study the impact of
cycle phases. We used this pool of properties to randomly select
10,000 portfolios for each size, ranging from one asset to the
total number of assets available. We calculated the standard
deviation of annual portfolio returns for each random selection
and studied the averages and dispersions in outcomes.
We used standard deviation as our measure of risk, which has
its drawbacks when applied to private real estate but allows us
to quantify the diversification impact of individual assets. While
the selection from our existing portfolio means that it is not
fully random, it has the benefit of being a sample that closely
resembles the market as the assets are part of a broad range of
strategies.
OUR ANSWERS
WHAT IS THE OPTIMAL NUMBER OF ASSETS?
Figure 1 quantifies how the portfolio risk decreases as it grows
in size. The left chart shows the risk level of a growing portfolio
as a percentage of the risk of a single asset. So, for example, the
standard deviation of a single US asset is 16.4 percent, but the
standard deviation for a portfolio of 30 US assets is on average
11.9 percent, such that 73 percent of the risk remains. In all
regions, enlarging the portfolio reduced the average portfolio
return volatility, but those incremental diversification benefits
declined with every further property.
At a certain portfolio size, the curve begins to level off and the
total risk approaches the undiversifiable market risk. Here, there
are differences across regions. For properties in our US sample,
the diversifiable specific risk is a smaller part of total portfolio
risk. This is also due to the composition of our sample. Properties
in our US sample are more homogenous, while the UK sample is
a broad composition of all major sectors. The more different the
properties, the more risk can be diversified away.
This is just one part of the story. The right chart of Figure 1
shows that bigger portfolios have a larger part of their specific
risk diversified away. With 11-18 assets, 90% of possible risk
reduction is achieved on average, depending on the region.
For an 85% reduction, this number declines to 8-11 while a
95% reduction would involve 21-35 assets. More assets will be
needed for markets with more varied assets, but the total risk
reduction for these types of markets will be larger. The practical
implication is that international portfolios will need to be larger
than domestic portfolios in order to eliminate the same share of
the specific risk and to replicate the underlying markets. But as
this specific risk comprises a larger share of total risk, the total
risk reduction may be larger. Hence, investing internationally
may increase diversification benefits provided the portfolio is
large enough.
In determining the “optimal number of assets”, it has to be
understood that the answer is subjective as it is not possible
to diversify 100% of all specific risk. Instead, a level that is
“sufficient enough” needs to be specified.
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©2015 CBRE GLOBAL INVESTORS, AMSTERDAM
DOES IT MATTER IF THE PORTFOLIO IS DOMINATED
BY A FEW ASSETS?
sample will be more heterogeneous than individual portfolios, it
remains clear that when portfolios consist of very different asset
sizes, more assets will be needed.
As in previous studies, the charts so far assume properties
of equal sizes. In reality, asset sizes in portfolios may vary
considerably. Therefore, it makes sense to do the same analysis
in value-weighted terms.
ROBUST IN A CRISIS?
For most regions, the standard deviation of larger properties
measured in value is somewhat lower than for smaller properties.
This reflects that such properties will more often be multi-tenants
or at more stable locations. When we use actual property
values to determine weighted average portfolio returns and
standard deviations, as in the right hand chart of Figure 2, larger
portfolios will be needed in order to achieve the same degree of
risk reduction compared with the left chart. This result is intuitive
as adding one bad asset to an existing portfolio can undermine
any diversification benefits. It will take more assets to allow the
specific impact of a large asset to be cancelled out. In order to
remove 90% of the specific risk, now 15-28 will be needed, and
for 95% this number rises to above 25. Although our total
One of the arguments used against international diversification is
that it works least when you need it the most: during a downturn
assets tend to behave more similarly than during an upturn.
We studied this relevant question with a US sample from 2006
onwards so that it comprises the severe crisis years 2008 and
2009. Our results show that this sub-period does not affect the
reduced share of the specific risk; even periods with two crisis
years require 17-20 assets to remove 95 percent of specific
risk. However, the sub-periods with the two crisis years have a
higher market risk and a smaller specific risk than the period
with only one crisis year. The practical inference from this is that
during crisis periods the diversification impact is indeed smaller,
although still present as larger portfolios still have lower risks.
FIGURE 2 THE IMPACT OF PROPERTY SIZE ON DIVERSIFICATION POTENTIAL
How much of the specific risk is diversified away if
the portfolio grows? (equal asset sizes assumed)
How much of the specific risk is diversified away if
the portfolio grows? (value-weighted) portfolio
PERCENTAGE
PERCENTAGE
100
portfolio grows?
100
95
95
90
90
85
85
NUMBER 0
OF ASSETS
10
20
30
USA
Netherlands
UK
Sweden
40
50
EMEA Other
60
NUMBER 0
OF ASSETS
10
20
30
USA
Netherlands
UK
Sweden
40
50
60
EMEA Other
WE DO NOT SHOW THE AVERAGE ACROSS REGIONS NOW AS RESULTS IN VALUE-WEIGHTED TERMS ARE HEAVILY INFLUENCED BY OUR SAMPLE COMPOSITION.
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FIGURE 3 AVERAGE AND MAXIMUM RISK AS FUNCTION OF PORTFOLIO SIZE
PERCENTAGE
portfolio
grows?
16
14
12
10
average
8
bandwidth of 1xSD
around average
(contains 67%
of all outcomes)
6
4
min and max
(contains 100%
of all outcomes)
2
0
NUMBER
OF ASSETS
0
10
20
30
40
50
60
RELYING ON AVERAGES?
Our figures so far have relied on averages. There is, of course,
a reasonable possibility that the portfolio risk exceeds the
average risk of 10,000 random selections. However, Figure
3 shows that the dispersion in outcomes decreases for larger
portfolios. This is because the standard deviation of the portfolio
returns decrease as the portfolio grows. The dotted lines show
a bandwidth of one times the standard deviation of the risk;
around two-thirds of all randomly selected portfolios will have
a risk within this bandwidth. But one third of portfolios will
have more extreme risks, as standard deviations for individual
portfolios can be much smaller or larger, depending on the
specific selections. The light green lines show the most extreme
risk values. Both these intervals diminish when the number of
assets increases.
The line for the maximum risk continues to decline for a much
larger number of properties.This means that to reduce downside
risk, true risk averse investors will need larger portfolios than
the average risk. In this global analysis, only at a portfolio size
of around 25-30 properties does the maximum risk reduction
start to level off. It should be noted that the minimum risk also
increases for larger portfolios. This is because after selection of
the most stable assets, less stable assets will have to be added to
let the portfolio grow.
PRACTICAL IMPLICATIONS
In general, the majority of risk mitigation through diversification
can be realised with 15 – 20 assets as our research based on
randomly selected portfolios shows. Actual portfolio construction
is however not a function of random selection and 10,000
chances. We have one chance to do it right but this is not simply
based on statistical chances. Smart portfolio selection can help
the odds of constructing a portfolio with a standard deviation
profile that is below the average of 10,000 random iterations.
Among the factors that we would take into account when
constructing portfolios are country, sector, city, economic base,
tenants, number of tenants, tenant industries and lease terms.
To translate the results into a portfolio size recommendation,
we have assumed typical asset values and a benchmark sector
allocation. This results in a portfolio of close to USD 1 billion
gross asset value over time. Of course, it is possible to invest in
bigger-sized or smaller-sized assets in many markets, resulting in
lower or higher value of portfolios.
We believe that diversification is just one element of risk and
there are several other risks to be considered and managed.
We take pride in RARE, our portfolio management and risk
assessment tool, and use this to recommend target markets and
sectors that we believe will create the best combination of risk
and returns that align with the portfolio objectives.
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