Risk Reduction and Tracking Error in Small Commercial Real Estate Portfolios

Abstract

Because of the extreme heterogeneity and lumpiness of commercial real estate, the topic of diversification and risk management has always attracted substantial interest, and a large body of work has been written on the subject. However, most of the analysis has focused on just a few markets, most notably the United Kingdom, or has been based on limited samples. This article uses asset-level data from over 9,000 office assets in the MSCI Global Annual Property Index to explore the performance of small portfolios (1 to 30 assets) over two separate five-year periods (2007–2011 and 2013–2017) in 16 national markets. The analysis focuses on small portfolios of fewer than 30 assets because many investors (even institutional investors and funds) have portfolios that are relatively small in terms of number of assets. The results provide a globally consistent overview of how asset correlations and market risk affected small commercial real estate portfolios and may have implications for the way investors and managers think about diversification in their exposures.

TOPICS: Real estate, risk management

Key Findings

• • Simulating the performance of commercial real estate portfolios with up to 30 assets suggests that even small portfolios can substantially reduce the amount of expected tracking error and volatility.

• • However, asset correlations vary considerably across markets and over time, meaning that estimates of risk reduction and diversification potential for one market during a specific period may be of limited use when applied to another market or a different period.

• • Investors may also wish to consider the fact that while the average portfolio can be expected to achieve a reasonable amount of diversification, individual portfolios cannot always be expected to behave like the average portfolio due to the heterogeneity of the asset class.