Introduction
Purpose of Diversification
Diversification of assets is intended to result in diversification of risks.
The prevailing literature focuses on several main concepts. First, diversification among investments within an asset class reduces the aggregate risks, i.e., the exposure to loss associated with an individual investment, when unique to that investment, can be reduced by diversification. Second, diversification among asset classes further reduces risk, i.e., to the extent that the volatility of returns are not highly correlated among asset classes, adding another asset class to the portfolio further reduces the aggregate risk. And, third, the risks considered in one and two are those associated with realizing a positive return, as well as getting the money back, i.e., those variously called economic risks or business risks.
A real estate perspective acknowledges the risk of not getting the money back, but when looking at real estate in a mixed asset portfolio, the investor is concerned with at least two additional risks. One is liquidity and the other is the price level risk. Real estate investment strategy holds that
"The idea of making the most money with the least risk is sheer nonsense. Making more money implies taking more risk of some sort. The risk could be that of not getting all or some of your money back, or that any money recovered would not buy as much as when originally invested. The risk could also be that of taking a loss in order to get your money back quickly. You can make more money by taking more of one or a combination of such risks."1
This is symbiotic with modern portfolio theory in that, first, diversification among different real estate investments that are not highly correlated will reduce the risk associated with not realizing a return of and on the original investment, and second, including real estate in a mixed asset portfolio will further reduce this risk. The real estate perspective differs in that it looks beyond the business risk and deals with the price level and liquidity risks.
Two major points need to be made. First, since the business risk is not the only risk, perhaps the other risks should also be diversified against. This may be in conflict with modern portfolio theory in that these risks may be considered non-diversifiable risks.
The second major point is that diversification by asset type, which is intended to reduce business risk, may actually be redundant, i.e., risk/return inefficient, because of the same underlying forces
The author wishes to acknowledge the assistance of Dr. Anthony B. Sanders, Professor of Finance, The Ohio State University, for his assistance in the development of this article, and Dr. John E. Williams, Professor of Business Administration, Chairman of Finance, Morehouse College for his review and editing of the article. impacting different forms of investment. What is more relevant is the idea that rather than focusing on form of ownership or interest in assets, the focus should be on diversifying the risks. This article starts with the risk diversification discussion of real estate in a mixed asset portfolio by first focusing on the business risk. The discussion then turns to price level and liquidity risks.
The paper draws heavily from some analyses conducted in construction of the Hoyt Model for real estate investment trust (REIT) valuation and risk assessment. In that model, the initial emphasis is on ascertaining real estate risks for the Hoyt Universe of 80+ REITs and examining the diversification obtainable in a REIT investment portfolio and then placing REITs in a mixed asset portfolio.
Mixed Asset Portfolio
Real estate investors may naively diversify by property type and location. Is this diversification of value to the investor? If the real estate is in a mixed asset portfolio and the other assets are impacted by the same variables such as industry or location, then the naive diversification is redundant, i.e., less than efficient in risk/return because of similar risks in different asset classes. For example, the returns from owning real estate in a small town dominated by a factory would most likely be highly correlated with the returns on the stock in the firm that owns the factory itself; as a consequence, diversification of business risk would be limited. Similarly, investors who own stocks and bonds of retail firms lose some diversification benefits when investing in shopping centers where the same firms are tenants. This type of diversification may be called redundant diversification. It is naive and inefficient.
In order to avoid redundant diversification, models for diversifying assets should focus on analyzing the relevant risk exposures. The models mights also price the risks. The Hoyt Model decomposes the cap rate and examines the risk premiums associated with the REITs. This technology can be applied to stocks, bonds, and other investment alternatives as well. The key risks that are examined are business risk, price level risk, and liquidity risk.
Macroeconomic Risk Factors
The value of stocks, corporate bonds, and related securities are impacted by business risks. These risks include the results of changes in the macroeconomy as well as results of changes in the regional and local economies. The sensitivity of a particular firm in a particular industry to changes in business risks is dependent on, among other things, the nature of the business and the degree of financial leverage used by the firm. The risk of loss associated a firm's ability to manage the impact of macroeconomic forces is sometimes called business risk.
One aspect of business risk which might be separately classified relates to the maturity structure of imbedded investments. While bonds usually have a fixed maturity, equities, stocks, and real estate investments generally do not have any maturity. The values are predicated in part by current income, and a market price which is a function of the income expectation and the cap rate. From one perspective, this is part of business risk. From another perspective, this is part of the liquidity risk.
In the capitalization of real estate income, the value of some real estate is dependent on leases which have a fixed maturity. That risk attributable to leases is closely associated with the risk attributable to bonds. The extent of risk varies with the lease duration and relative size of lease income. The analysis of the maturity structure of assets, such as leases, is important in assessing the business risk because the leaseholders have the added security of credit, as well as the marketability of the space.
The economic risks that impact all investments include industrial production and other economic activity and are reflected in various measures of the economic activity. Ongoing research efforts attempt to identify which of the macroeconomic variables is most important in understanding the economic risks associated with investments in different assets and how the changes in the structure of industry products will have a different impact.
Microeconomic or Idiosyncratic Risk Factors
There are a number of business risk factors that are localized (such as import substitution industries). For example, different regions or urban areas will generate different business risks than others. Furthermore, different property types will have different business risks than others. While these business risks can be naively diversified away to some extent by holding a portfolio with properties in different parts of the country or in different property types, it may be the case that a portfolio manager may (depending on local economy) be able to achieve the same diversification elsewhere in the portfolio by combining various positions in stocks, bonds, and real estate. An important element of the Hoyt Model is the ability to determine which one of the microeconomic or idiosyncratic risk factors are important and how much diversification of risk is contributed by those factors. This is especially important because the market pays a premium for liquidity.
An Integrated Approach
An integrated approach to business risk focuses on industry structure. In real estate investment, the consideration of the economy starts with attention to the local economy. It is the hub through which the demand for real estate is generated. The impact of the national and international economic forces is defined by local consumption, which becomes the focus of analyses.
While the demand for different types of real estate have different relationships to the structure of the local economy, a basis for diversification among structural economic forces is diversification of economic bases. The location quotients (analytical techniques using proportionality comparisons, such as the comparison of the percentage of an activity in a city with the percentage of the same activity in the nation)2 can identify dominant local industry.
The analyses of real estate in a mixed asset portfolio can then start with diversification of core types of real estate in selected metro areas and then diversify among metro areas. Once the diversification of metro areas is accomplished, the dominance of SIC classifications, if any, is compared with the dominance, if any, of industries in which stock and bond investments have been made.
Thus, the business risk goes back to industry selection (giving consideration to correlation between industries) and the first analysis is a macro analysis to determine which sectors, if any, deserve a heavy bet, or if the intent is to fully diversify where the industry diversification is obtained, i.e., stock, bonds, or real estate.
Once the sector bets are selected, a shift share analysis, which decomposes a region's growth into different components, including the effect of a region's industrial mix3, may be made to select metro areas which will capitalize on the underlying trends.
While this analytical system utilizes old tools, it is a new paradigm. The old supply/demand relationships of market analyses are not lost. They are simply placed in the context of long-term bets.
Another risk that is important to investors is that of rising price levels, i.e., inflation risk. Each investment opportunity in the economy behaves somewhat differently with respect to inflation. For example, real estate investments with long-term leases that have automatic CPI adjustments are less likely to be affected by inflation than comparable real estate investments with long-term fixed leases without CPI adjustments. By carefully analyzing REITs, the Hoyt Model can determine the sensitivity of different investment vehicles to inflation, both expected and unexpected. The real estate market rents provide some response to unexpected inflation. Some diversification against price level risk is available in a diversification REIT portfolio.
Bond investors deal with the risk of inflation by getting interest rate premiums to compensate for the expected rate of inflation. Sometimes the risk is partially shifted to the borrower with floating rates. But, real estate investors may have a hedge against inflation in that rents may rise along with the general level of prices. Investors may be willing to accept the price level risk of bonds in order to reduce the business risks which would be imbedded in equity investments that provide better protection from inflation.
The case for stocks is significantly more complicated. It depends on the product or service price flexibility and on debt structure as well as other factors. Thus industry and individual company analyses are necessary to assess the price level risks associated with stocks. So, stock investments may be analyzed for both business risk and sensitivity to price level risks which may, in turn, impact business risk.
REITs are a special case of real estate investment or stock investment, depending on your point of view. The price level risks are high for REITs specializing in long-term net leased properties unless there is some form of indexing, and low for short-term leased properties such as apartments.
The thrust of this commentary on diversification is to move toward risk quantification as part of a process of diversifying by developing a mixed asset portfolio. Fortunately, the US Treasury has recently issued a CPI-indexed note so that there is an objective measure of expected inflation over ten years tied to the bond market. In the Hoyt portfolio, different REITs are selected with consideration given to purchasing power risk.
While price level risk may be viewed as part of economic risk, there is merit in separating it out as a risk component of diversification.
Liquidity risk is the chance of loss from quickly converting the asset to cash. The two main elements are the length of time to maturity, if there is a maturity, and the organization of the market. The length of time may be thought of as maturity risk or the risk of change in the interest rate or cap rate which would negatively affect capital value in the event of sale. The event of sale is an important consideration to which we will return.
Bonds have maturity dates. Stocks and real estate do not. Thus, the way to get out of the investment which has no maturity date is a sale.
In the case of stocks there may be a well-organized market with a low transaction costs, thus the liquidity is greater than generally obtainable with real estate investments.
It makes sense to diversify liquidity risk as well as other risks. The best liquidity is obtained from short term debt instruments for which there is a well-organized market. Secondary sources of liquidity may also be used. Real estate is an illiquid asset. The investor expects and may get a premium for giving up liquidity by real estate investing. Thus the mixed asset portfolio should be structured to allow for the flexibility in determining the timing of sale of the real estate assets.
Again, as noted earlier, the maturity may be partly dealt with as part of the business risk.
Sophisticated economic models allow researchers to examine a portfolio of investments and determine the degree to which the portfolio is exposed to various risks. Thus, portfolio managers can increase/decrease positions in certain industries or asset types to remain hedged against (or speculate on) key economic events, such as a large change in long-term government interest rates. Furthermore, these econometric models of asset returns can detect predictable components of asset returns which permits portfolio managers to create positions to take advantage of this information.
An econometric model that allows the portfolio manager to adequately diversify, and efficiently manage systematic risks, and which is based on the risk decomposition methodology discussed in this paper needs to be developed.
Investors, at whatever level of sophistication they choose, may receive the diversification benefits of real estate investments. They do this by including real estate as an asset class in the portfolio. By using REITs, the investor can generally enhance liquidity and depending on spreads between main street and wall street cap rates, also receive the asset management benefit, sometimes at little or no additional cost. But, not all REITs are the same, and by looking through the asset form to the underlying risks, REITs may be used in combination with stocks and bonds to build an efficient frontier with better risk/return relationships than obtainable by focusing on the form of asset ownership rather than the risks.
The author wishes to acknowledge the assistance of Dr. Anthony B. Sanders, Professor of Finance, The Ohio State University, for his assistance in the development of this article, and Dr. John E. Williams, Professor of Business Administration, Chairman of Finance, Morehouse College for his review and editing of the article.
- Maury Seldin and Richard H. Swesnik. Real Estate Investment Strategy. John Wiley & Sons, Inc., New York, 1970, P. 2.
- Arthur M. Weimer, Homer Hoyt, and George F. Bloom. Real Estate. John Wiley & Sons, Inc., New York, 1978, p. 664.
- Denise DiPasquale and William C. Wheaton. Urban Economics and Real Estate Markets. Prentice Hall, Englewood Cliffs, NJ, 1996, p. 167.
When Adam and Eve left the Garden of Eden, the conversation might have included the comment, "you know we live in an era of transition." What has changed over time is the character of transition and the pace.
It took a long time to become an agrarian society, and then a long time before we became an industrial society. The post industrial society has come upon us quickly.
Elsewhere, I have commented on the impact of the information revolution on real estate analyses. My comments tonight are on our participation in transition.
"Brother Can You Paradigm"
If I may be permitted, "Brother, can you Paradigm." Puns are the worst form of humor, when made by someone else. The original saying "Brother Can You Spare a Dime," was depression born, as was I.
The transition, in my lifetime, so far has been wondrous, astounding. The pace accelerated in recent decades, and I have focussed on the big picture changes. Kuhn, who gave us the concept of paradigm shift, recently ended his days. His concepts live on, however. Most relevant is that most of us are working on the edges of the paradigm. And, I would add, as a learned and close colleague commented, have an interest in the status quo.
What I saw here, two years ago, if my recollection is correct about the time, was the emergence of a shift in the concept of portfolio diversification. The four quad approach to diversification (public, private, debt, equity) was under discussion, and I went into my office to sketch out a 3-D matrix by type of risk.
That, pieced with the information revolution, with technology now available, can develop into the top sight approach described by Gelernter in his landmark book Mirror Worlds.
It is my belief that these changes, will further change the way we conduct analyses, the way we make decisions, and the institutional arrangements under which this investment industry operates.
We brought to you here at the Weimer School, for this session, some of the thought leaders from industry. They are providing a glimpse of the transition now underway. And, transition in which you may be a part.
My Transition -- Your Transition
My transition, with my retirement from HHI, is for a shift to the big picture concepts and their application in specific cases to demonstrate the validity of the concepts. Also, I believe, these efforts will fund the resumption of our generous grant program -- in one form or another.
Your transition with the Weimer School, under the leadership of Ron Racster, is for a greater participation in governance of this institution. It is a carrying forward to the next generation, not only being at the cutting edge, and doing the cutting, but, bridging the gap between academia and industry.
Your transition, may also include participation in the emergence of a new paradigm. It is one being built upon the information and technology revolution. It is one which extends modern portfolio theory to deal with the different types of risks, and, changes society's structure or environment which brings the risk results in different combinations.
Most of you can meet the peer pressures in the existing "Glass Beads Game" (Herman Hessee) with your left hand. What will probably count the most for advancing the state of the art is what you do with your right hand.
Your right hand, your right arm, is the symbol of strength. Your strength will provide the greatest use to society -- and I believe to you personally, if it capitalizes the big picture and makes the contribution in knowledge which is needed at the edge to flesh out the new paradigm.
Retirement/Commencement
In a sense, my comments tonight are on the occasion of my retirement from HHI. They are also in the nature of a commencement address.
We have five new Fellows. I congratulate you. This commencement address, or set of comments, is for you and the other Fellows of the Weimer School.
Go Jaguars -- or whatever we call ourselves. All of us are part of an expansion team. Good luck out there!