Chris is responsible for analyzing, valuing and marketing properties for the NAI Alliance Investments Team. He is also involved in the disposition and acquisition of investment properties for clients.
Diversification, it’s one of the prominent terms associated with investment portfolios. We are beaten over the head with this word almost every time the word portfolio is mentioned. With all of the air time the word gets you would think that everybody would firmly grasp the concept and know how to apply it to their current portfolio right? The answer may surprise you.
Many people interpret diversification as the act of adding an asset to their existing portfolio that is in a different class, or sector, than the assets they currently own. On the surface that assumption makes sense, but many times those assets can end up performing exactly the same as some of the assets they already own i.e. they have a high correlation coefficient. To truly understand diversification you have to know how to interpret correlation coefficients and more importantly the modern portfolio theory and the capital asset pricing model (CAPM). Since that is a whole other topic and concept I’ll spare the in-depth analysis and get to the overall point. The optimal diversification of a portfolio is achieved by adding assets that increase the portfolio return without adding any additional portfolio risk. That usually translates to assets with low correlation coefficients with respect to the portfolio and a majority of their risk being diversifiable. So what does this all mean to a real estate investor?
Since it is nearly impossible to create a standard deviation for an individual commercial real estate asset we have to turn to the REIT world to get our data for an apples to apples analysis. I used the NAREIT Equity REITs Index’s monthly returns going back to 1972. I compared that data to the monthly returns of the Dow Jones Industrial Average and the Standard & Poor’s 500. Below is the correlation table for their historical returns.
As we can see the correlation coefficient for the ^DJI and ^GSPC is close to 1, which means that their returns almost mirror one another, as we’d expect. The 0.54 and 0.56 coefficients that they share with the Equity REIT means that if you were to combine either of them with the Equity REIT you would be able to diversify out some of the individual asset risk that each possesses as a standalone asset. The ultimate goal is to have the maximum return for your specific risk threshold. Adding commercial real estate to a portfolio is one of the ways to reach that frontier. One of the services we offer is helping clients determine the right price to pay for a commercial property that will create an optimal return for the risks they will be incurring.
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