Journal of Real Estate Portfolio Management

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Measuring the Effectiveness of Geographical

Diversification

Ping Florida & Stephen Roulac

To cite this article: Ping Florida & Stephen Roulac (2007) Measuring the Effectiveness of
Geographical Diversification, Journal of Real Estate Portfolio Management, 13:1, 29-44, DOI:
10.1080/10835547.2007.12089761

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Published online: 18 Jun 2020.

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 Measuring the Effectiveness of Geographical
Diversification
Executive Summary. How many markets does it take
to form a geographically well-diversified portfolio? Using
a simulated approach, this study investigates the effect-
iveness of geographic diversification across the metro-
politan areas in the United States. Four diversification
schemes, the ‘‘Mixed MSA,’’ ‘‘Large MSA Only,’’ ‘‘Simul-
taneous,’’ and ‘‘Large MSA by Property Type,’’ are ana-
lyzed. 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 nonsyste-
matic 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.
* Florida Atlantic University, Boca Raton, FL 33431 or
pingcheng888@yahoo.com.
** The Roulac Group, San Rafael, CA 94901 or
experts@roulac.com.
by Ping Cheng*
Stephen E. Roulac**
Geographic diversification is considered as an im-
portant portfolio strategy by most real estate in-
vestors. In an early survey of the investment prac-
tice of real estate investment trusts (REITs), Webb
and McIntosh (1986) reported that, among inves-
tors 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 at-
tempt to diversify across geographic locations,
their choices seem to be limited to a few so-called
‘‘core locations.’’ Shilton and Stainley (1995) sur-
veyed the NCREIF property database and found
that institutional real estate investments are
highly concentrated in large counties and/or met-
ropolitan areas. Their findings indicate that about
30% of NCREIF properties are located in the seven
largest counties, 45% in the largest fifteen coun-
ties, 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 coun-
ties in the United States, such high concentration
of institutional real estate holdings raises ques-
tions as to the effectiveness and appropriateness of
institutional investment strategies.
For example, are those institutional portfolios well
diversified? How much risk is (or is not) eliminated
Journal of Real Estate Portfolio Management 29
Ping Cheng and Stephen E. Roulac
by diversifying across only those ‘‘core locations’’?
More generally, in how many different markets
must one invest in order to achieve good geo-
graphic diversification? And how should the ef-
fectiveness of geographic diversification be mea-
sured? Numerous studies have proposed various
geographic/economic diversification strategies, but
few have attempted to quantify the effectiveness
of the strategy. This study takes up the task and
examines the question of how many markets
make a geographically well-diversified real estate
portfolio.
It is important to distinguish the question of ‘‘how
many markets’’ from the question of ‘‘how many
properties.’’ First, the latter is analogous to the
question of how many stocks make a well-
diversified stock portfolio, while the former focuses
on examining the relative and proportional reduc-
tion of total risk by investing in multiple markets
versus concentrating in a single market. Second,
given the heterogeneous nature of real estate mar-
kets within MSAs, a significant degree of diversi-
fication may be achieved within a single MSA by
selecting properties in different sub-markets of the
city (Rabianski and Cheng, 1997; and Wolverton,
Cheng, and Hardin, 1998). For example, a simple
‘‘indexing’’ of sub-markets within an MSA may re-
move some of non-systematic risks of properties.
Thus the question of ‘‘how many markets’’ only
deals with the residual non-systematic risk that
remains after diversification from indexing within
a city. In other words, assuming investors can
achieve a certain degree of within-city diversifica-
tion, how much more beneficial is it to invest in
multiple MSAs for additional risk reduction? This
study attempts to shed some light on this issue.
It is well documented in the finance literature that
portfolio risk reduction is a function of the number
of assets in the portfolio, as well as the average
correlation among those assets. Evans and Archer
(1968) provided perhaps the first study on the is-
sue and suggested that a portfolio with ten or so
randomly selected stocks can effectively eliminate
most of the diversifiable risk. Elton and Gruber
(1977) developed an analytical model that quanti-
fies the effect of portfolio size and asset covariance
on portfolio risk. While for many years the consen-
sus had been that ten or so stocks are sufficient to
30 Vol. 13, No. 1, 2007
form a well-diversified portfolio, such consensus
was challenged by Statman (1987). By comparing
the marginal benefit to marginal cost of diversifi-
cation, Statman concluded that it is beneficial to
increase portfolio sizes to thirty or so stocks for a
borrowing investor and forty or so stocks for a
lending investor. Today most finance textbooks
concur that portfolios with thirty to forty randomly
selected stocks can diversify away nearly all the
nonsystematic risks, which accounts for about 60%
of the average total risk of individual stocks.
Few studies have directly addressed the question
for real estate. DeWit (1997) used twenty-nine
property-specific return series to measure the port-
folio risk reduction in the U.S. and found that as
much as 94% of individual properties’ variance can
be eliminated. In a study of the return distribu-
tions of real estate, Young and Graff (1995) sug-
gested that it takes a large number of properties
to eliminate the non-systematic risk of real estate
portfolios. While not quantifying the benefits of di-
versification, a number of studies have investi-
gated the return and risk attributes of real estate
property as well as portfolios. Hartzell, Hekman,
and Miles (1986) used data from a large open-end
CREF to estimate the proportions of systematic
risks in real properties. They also estimated that,
for the period from 1978 to 1983, the average cor-
relation coefficients of their sample properties
were 0.09 for quarterly data and 0.19 for annual
data, indicating potential benefit of diversification.
Also using CREF data from a different source,
Dokko, Edelstein, Pomer, and Urdang (1991) de-
veloped a return index for the period from 1976 to
1984 and estimated the variance of the index to be
about 4.2, which is about 81% reduction from the
average variance of individual properties. Grissom,
Kuhle, and Walther (1987) used simulated trans-
action prices for two cities in Texas and found that,
for example, portfolios of ten properties may re-
duce the average variance of single properties by
about 58%, which translates into about a 35% re-
duction of standard deviations. Webb, Miles, and
Guilkey (1992) use quarterly NCREIF data for the
1980–1988 period and find the average correlation
coefficients for transaction based data to be 0.014
and for appraisal-based data to be 0.055.
The purpose of this study is to investigate the
marginal benefit of diversification across multiple
 Measuring the Effectiveness of Geographical Diversification

MSAs as opposed to investing in a single MSA. The will approach the average covariance of all assets
data used in this study are the NCREIF property in the market. That is:
indices in various MSA and submarkets. This im-
plies that indexing within MSAs already removes ␴M
2
⫽ ␴jk, (2)
portions of non-systematic risk of portfolios.
The question is: How much more beneficial it is where ␴M 2
indicates the minimum risk achievable
to invest in multiple MSAs for additional risk by forming equal-weighted portfolios. In a Mar-
reduction? More specifically, the research inves- kowitz style diversification, the portfolio weights
tigates the following questions and quantita- are allowed to differ, and portfolio risk may be
tively measures the effectiveness of geographic reduced to below ␴M 2
. The focus of this paper is
diversification: limited to equal-weighted diversification. The
1. Assuming investors can invest in any city in additional risk reduction from Markowitz style di-
the U.S., in how many cities must investors versification will be investigated in a separate
spread their capital to achieve good geographic study.
diversification?
2. What will be the maximum portfolio risk reduc- Since typical real estate portfolios contain finite
tion if geographic diversification is limited to numbers of properties, and property returns are
only the largest cities in the U.S.? not perfectly correlated, the following is generally
3. Given the limit of investing only in large cities, true:
can additional risk reduction be obtained by ex-
tending diversification to the intra-city level? ␴M
2
⬍ ␴P2 ⬍ ␴i2. (3)
4. How do different types of properties behave in
various diversification schemes? The effect of diversification can be measured in two
ways. The first is by the ratio of portfolio standard
deviation to the average standard deviation of sin-
Research Methodology gle assets. That is:

According to Elton and Gruber (1995), the total

␴P
risk of an equal-weighted portfolio can be mea- B⫽ . (4)
sured by the variance of its returns: ␴j

1 This ratio indicates the percentage of average in-

␴P2 ⫽ (␴ 2 ⫺ ␴jk) ⫹ ␴jk. (1) dividual assets’ risks that remains in an N-asset
N j
equal-weighted portfolio. The average risk reduc-
tion from single-asset portfolios is then 1 ⫺ B. Sub-
Where: stituting Equation 1 into Equation 4 yields:

␴P2 ⫽ The variance of returns of an equal-weighted

portfolio;
N ⫽ The number of assets in the portfolio;
B⫽
␴P
␴j
⫽ 冪 ␴P2
␴j2

N 冉␴ 冊
␴j2 ⫽ The average variance of individual assets (j
⫽冪 ⫹
1 N⫺1 ␴ jk
⫽ 1 . . . N); and , 2
(5)
N j
␴jk ⫽ The average covariance of all assets in the
⫽冪 ⫹
portfolio (j, k ⫽ 1 . . . N). 1 N⫺1
␳ jk
N N
This equation shows that the total risk of a port-
folio consists of two parts. As portfolio size N in- where ␳jk ⫽ ␴jk / ␴j2 is the average correlation
creases, the first term decreases. Assuming there coefficient of assets in the portfolio. Obviously, as
is a sufficiently large number of assets in the mar- N approaches infinity, B approaches 兹␳jk. Notice
ket, then an equal-weighted market portfolio’s risk that, while correlation coefficient of any two assets

Journal of Real Estate Portfolio Management 31

Ping Cheng and Stephen E. Roulac
can range between ⫺1 and ⫹1, the average corre-
lation coefficient among N assets, ␳jk, can only
range between 0 and ⫹1. Therefore, given an un-
limited number of investment opportunities, the
maximum reduction of portfolio standard deviation
is (1 ⫺ 兹␳jk). Equation 5 shows that portfolio risk
reduction is a function of the number of assets in
the portfolio and the average correlations among
those assets.
Another measure of the diversification effect is by
the following ratio:
␴P ⫺ ␴M
K⫽ . (6)
␴P
This ratio indicates the percentage of portfolio risk
that is not eliminated by the diversification. That
is, it is the remaining portion of diversifiable risk
of the portfolio. The higher the K, the less effective
is the diversification. Substituting Equations 1 and
2 into Equation 6 yields:
␴M
K⫽1⫺
␴P
␴jk
冪
⫽1⫺ . (7)
1 of these property types may be missing from their
(␴ 2j ⫺ ␴jk) ⫹ ␴jk
N
␳jk
冪
⫽1⫺
1 N⫺1
⫹ ␳jk
N N
Again, it can be seen that portfolio risk reduction
is a function of the number of assets in the port-
folio and the average correlations among those as-
sets. As N approaches infinity, K approaches 0,
which indicates the maximum risk reduction.
To use the ratios of Equations 5 and 6 to measure
the effect of geographical diversification, there
must first be estimates of ␴P2, ␴M
2
, and ␴i2. This is
accomplished by employing a simulation process.
Specifically, given a number of n real estate return
indices of various MSAs, each return index is
treated as an observation of the sample. Next, a
randomly drawn N (N ⫽ 1 . . . n) observations from
the sample (without replacement) is used to form
one N-asset equal-weighted portfolio. The variance
32 Vol. 13, No. 1, 2007
of the random portfolio and the average covariance
of the N randomly selected assets are then calcu-
lated and saved. The process is repeated 1,000
times to obtain 1,000 average correlation coeffi-
cients and portfolio standard deviations for each N
(N ⫽ 1 . . . n). These 1,000 simulated results permit
the determination of empirical distributions of cor-
relation coefficients and portfolio standard devia-
tions, based on which statistical inferences can be
made. Three geographic diversification schemes
are investigated using this general simulation
process.
First, there is an examination of a ‘‘Mixed MSAs’’
scheme. Here it is assumed that investors have no
capital constraints and can invest in any number
of cities. It is also assumed there is no transaction
cost, and investors are indifferent to all cities, big
or small.
The aggregated MSA total return indices from the
NCREIF data set are used to analyze this scheme.
Each of these indices is the average quarterly re-
turn of all properties reported within an MSA. For
most large MSAs, the indices reflect the average of
five types of properties—apartment, industrial, of-
fice, retail, and warehouse. For small MSAs, some
indices. These indices are used as indicators to ap-
proximate the performance of the overall real es-
tate market in various cities.
Second, there is an examination of a ‘‘Large MSA
Only’’ scheme. Large MSA is defined here as the
top thirty most populous MSAs in the U.S. based
on the 2000 Census data. Shilton and Stainley
(1995) suggested that institutional investors do not
view all metropolitan areas indifferently; rather,
their real estate holdings are largely concentrated
in the top thirty counties. The first justification for
so doing seems to be that investors rely on the
‘‘rule of 15,’’ as proposed by Elton and Gruber
(1981), which holds that fifteen distinct positions
are sufficient for minimizing a portfolio’s nonsys-
tematic risk. However, it seems that Elton and
Gruber themselves now have come to believe that
it takes a lot more than fifteen stocks to eliminate
all the nonsystematic risks from a portfolio. The
second justification for a highly concentrated strat-
egy seems to be the managerial cost associated
 Measuring the Effectiveness of Geographical Diversification

with diversification. According to the economic law sub-indices were extracted from the indices that
of increasing marginal cost, diversification be- ended at the fourth quarter of 2004. Those with
comes increasingly costly as investors expand their return series that were shorter than 32 quarters
holdings into more metropolitan areas. Although a or had missing values in the last 32 quarters were
concentrated strategy may be justifiable, empirical eliminated. This criterion is somewhat arbitrary
evidence is lacking as to at what point marginal and is only intended to ensure the time-series are
cost exceeds the marginal benefit. This is an issue statistically valid. After the screening, the data set
that warrants a separate investigation. The cur- contained 244 sub-indices for analysis. The time
rent study ignores the marginal cost of diversifi- span of the sample is from the first quarter 1993
cation and only examines the effectiveness of a to the fourth quarter 2004. Exhibit 1 displays the
‘‘Large MSA Only’’ scheme in comparison to the break-down of these sub-indices by categories.
other schemes.
The NCREIF indices are used as proxies for port-
Third, there is an examination of a ‘‘Simultaneous’’ folios already diversified somewhat within MSAs
scheme. Hudson-Wilson (1987) suggested that di- or submarkets. No inference is made between the
versification by geographic location and by prop- indices’ risk and return to those of individual prop-
erty type should be conducted simultaneously erties. In other words, the validity of these indices
rather than sequentially. Following this idea, the
property sub-indices in the NCREIF data set are
also used. Each index represents the average re-
turn of a property subtype. There are total 124 Exhibit 1
sub-indices for the thirty largest MSAs, each of Final Sample Breakdown by Region and
which is treated as an individual asset, such as Property Type
Atlanta-apartment, Boston-office, Chicago-retail, East Midwest South West Total
Dallas-industrial, etc. The simulation process is Panel A: Number of return sub-indices by property type and by
then performed on the set of sub-indices, and the regions
ratios of Equations 5 and 6 are calculated.
MSA-All types 20 11 18 17 66
Apartment 9 0 14 12 35
Fourth, there is an examination of a ‘‘Large MSA Industrial 8 7 9 11 35
by Property Type’’ scheme. Here the ‘‘Large MSA Office 14 12 7 17 50
Retail 4 4 9 15 32
Only’’ scheme is repeated for five different property Warehouse 7 6 5 8 26
types and there is an examination of whether they
Panel B: Descriptive statistics
exhibit different diversifying abilities. All property
types are not equal in the eyes of investors. The Quarterly Average
weights of property types in institutional portfolios Mean Quarterly Return Number of
Property Return Std, Dev. per Unit Number Properties
vary from fund to fund and over time. Therefore, Types (%) (%) of Risk of MSAs per Indices
examining this issue offers additional insights into
All types 2.50 1.09 2.29 66 28
proper asset allocation by property types. And it is Apartment 2.90 0.56 5.17 35 11
also interesting to see whether investors recognize Industrial 2.87 1.08 2.65 35 20
and take advantage of the different diversifying Office 3.03 1.84 1.65 50 17
Retail 1.76 1.20 1.47 32 13
characteristics of various property types.
Warehouse 2.84 1.02 2.79 26 16

Data
The published quarterly NCREIF property indices
are chosen for the analysis. The indices were com-
piled at MSA level for twelve sub-types of com-
mercial properties. An average return is reported
for a certain quarter if there are at least four prop-
erties of a same sub-type in that MSA. A total 316
Notes: The NCREIF indices were compiled at the MSA level for twelve
sub-types of commercial properties. An average return is reported for
a certain quarter if there are at least four properties of a same sub-
type in that MSA. A total 244 sub-indices were extracted from the
indices ended at 4th quarter 2000 that have no missing values in the
last 32 quarters. The time span of the sample is from 1993:Q1 to
2000:Q4. Return per unit of risk is computed as the mean return
divided by the mean risk. The best performing sector seems to be the
apartment (5.17) and the worst sectors are office (1.65) and retail
(1.47).

Journal of Real Estate Portfolio Management 33

Ping Cheng and Stephen E. Roulac
is not the concern of this study. Therefore, no at-
tempt was made to correct the various biases as-
sociated with property indexing [i.e., the appraisal
bias (Giliberto, 1998; and Geltner, 1989), the sam-
ple selection bias (Munneke and Slade, 2000), the
transformation bias (Shiller, 1991; and Goetzmann
and Peng, 2002), or the aggregation bias (Good-
man, 1998; and Geltner, 1993).
Results
First, an estimate was made of the minimum risk
possible for the equal-weighted portfolios in order
to measure the effectiveness of the four diversifi-
cation schemes. According to Equation 2, the min-
imum achievable variance of equal-weighted port-
folios is the average covariance of all assets in the
market. Using the entire sample, the average cor-
relation coefficient of all the indices was estimated
to be ␳jk ⫽ 0.13 and the average variance ␴j2 ⫽ 1.78.
Since ␴jk ⫽ ␳jk ␴j2, plug in Equation 2 to yield ␴M 2
⫽ 0.13 ⫻ 1.78 ⫽ 0.64, which is the minimum
achievable risk through diversification.
The ‘‘Mixed MSA’’ Scheme
The sample contains 66 MSA return indices.
Equal-weighted portfolios of N randomly drawn as-
sets (N ⫽ 1 . . . 66) were formed using the simu-
lation process described in the methodology sec-
tion. The average standard deviations for each
portfolio were then calculated. The results are
summarized in Exhibit 2. It is apparent that, as
the number of cities in the portfolio increases,
mean portfolio risks decline, but at a decreasing
speed. For example, a portfolio diversified across
over ten randomly selected cities is subject to only
51% of the average risk presented by a single city.
But when a portfolio is expanded to thirty cities,
the portfolio risk is still about 46% of the average
risk of single cities, and the portion of portfolio risk
not eliminated by diversification is 22%. The max-
imum risk reduction when taking diversification
across all the sixty-six MSAs is about 60% (⫽ 1 ⫺
40%). At that point, 90% of the diversifiable risk is
eliminated, as indicated by K. Exhibit 3 illustrates
the relationship between portfolio size and risk.
Two points may be noted. First, the curve of mean
portfolio risk becomes virtually flat when the num-
ber of MSAs exceeds fifteen or so. Second, the con-
fidence intervals of mean portfolio risks are rather
34 Vol. 13, No. 1, 2007
wide when the number of MSA is less than twenty.
This suggests that there is great amount of un-
certainty associated with the amount of risk
reduction.
The Large MSA Only Scheme
When diversification is limited to the thirty largest
MSAs, the effectiveness of the strategy is signifi-
cantly reduced. Exhibit 4 displays the results of
the analysis. It is obvious that, for portfolios con-
sisting of less than thirty MSAs, the percentages
of risk reduction in Exhibit 4 is much less than
those presented in Exhibit 2 for any number of
MSA portfolios. For example, a 10-large -MSA
portfolio is subject to about 71% of the average risk
of single MSAs, compared with the 49% for the
Mixed MSA scheme. The maximum of risk reduc-
tion, when diversify across all the thirty largest
MSAs, is 1 ⫺ 68% ⫽ 32%; whereas in Exhibit 2,
the risk reduction with thirty MSAs is 1 ⫺ 40% ⫽
60%. Most portfolios’ K remains above 45%, indi-
cating about half of the portfolio risks are not elim-
inated by the diversification scheme. Exhibit 5 il-
lustrates the relationship between portfolio size
and risk reduction for the Large MSA Only
scheme. Notice that the curve of mean portfolio
risk stays well above the line of minimum achiev-
able risk. And the curve of K remains rather flat,
indicating increasing portfolio size does not effec-
tively reduce portfolio risk. This confirms the hy-
pothesis that geographic diversification across only
the largest MSAs is not very effective, largely be-
cause markets of large cities are more highly cor-
related. Thus the dilemma: on one hand, for geo-
graphic diversification to be effective, investors
should mix large and small cities; on the other
hand, since small cities usually have less institu-
tional grade properties, it is often not possible to
include small cities in the portfolio. Therefore, ef-
fective diversification across only the largest cities
must be modified in a way that increases the num-
ber of investment opportunities.
The ‘‘Simultaneous’’ Scheme
One possible way to modify the previous asset al-
location scheme is to consider geographic and
by-sector diversification simultaneously. Instead of
using the aggregated MSA total return indices,
 Measuring the Effectiveness of Geographical Diversification

Exhibit 2
Average Portfolio Risk Reduction and the Number of MSAs in the Portfolio
Number of Properties 95% Confidence Interval of Portfolio
Contained Risks
Number of Mean Portfolio
MSAs Minimum Maximum Risks (%) Lower Bond (%) Upper Bond (%) Ba Kb

(1) (2) (3) (4) (5) (6) (7) (8)

1 5 112 1.78 0.89 3.49 100 64

2 10 210 1.44 0.78 2.58 81 56
3 16 292 1.18 0.69 1.86 66 46
4 22 373 1.11 0.68 1.68 62 42
5 28 454 1.04 0.63 1.47 58 38
6 35 535 1.01 0.74 1.44 57 37
7 42 601 0.95 0.69 1.29 54 33
8 49 656 0.95 0.68 1.24 53 32
9 57 711 0.91 0.64 1.20 51 30
10 65 761 0.91 0.61 1.13 51 30
11 73 808 0.89 0.62 1.10 50 28
12 82 854 0.89 0.56 1.10 50 28
13 92 899 0.89 0.65 1.05 50 28
14 102 942 0.87 0.62 1.04 49 27
15 113 978 0.86 0.62 1.04 48 25
16 125 1011 0.86 0.64 1.05 48 26
17 137 1043 0.85 0.63 1.03 48 24
18 149 1074 0.84 0.62 1.04 47 24
19 161 1105 0.83 0.59 1.02 47 23
20 173 1132 0.83 0.64 1.01 47 23
21 186 1158 0.84 0.58 1.00 47 24
22 200 1184 0.84 0.59 0.98 47 24
23 215 1209 0.84 0.67 0.99 47 24
24 230 1234 0.84 0.62 0.97 47 24
25 245 1259 0.83 0.65 0.97 47 23
26 261 1283 0.84 0.63 0.96 47 24
27 277 1306 0.84 0.62 0.94 47 24
28 294 1328 0.84 0.65 0.96 47 24
29 311 1349 0.82 0.64 0.94 46 22
30 328 1369 0.82 0.65 0.91 46 22
31 345 1389 0.82 0.64 0.90 46 22
32 363 1408 0.84 0.61 0.90 47 23
33 381 1426 0.82 0.60 0.88 46 22
34 399 1444 0.82 0.64 0.88 46 22
35 418 1462 0.80 0.64 0.88 45 20
36 438 1479 0.79 0.65 0.88 45 19
37 458 1496 0.80 0.67 0.87 45 20
38 479 1513 0.79 0.63 0.87 44 19
39 501 1530 0.81 0.64 0.89 45 21
40 524 1546 0.80 0.64 0.88 45 20
41 548 1562 0.81 0.64 0.86 45 21
42 573 1577 0.81 0.65 0.85 45 21
43 598 1592 0.82 0.65 0.85 46 22

Journal of Real Estate Portfolio Management 35

Ping Cheng and Stephen E. Roulac

Exhibit 2 (continued)
Average Portfolio Risk Reduction and the Number of MSAs in the Portfolio
Number of Properties 95% Confidence Interval of Portfolio
Contained Risks
Number of Mean Portfolio
MSAs Minimum Maximum Risks (%) Lower Bond (%) Upper Bond (%) Ba Kb

(1) (2) (3) (4) (5) (6) (7) (8)

44 623 1607 0.82 0.67 0.84 46 22

45 649 1621 0.81 0.70 0.84 45 21
46 675 1634 0.81 0.72 0.83 45 21
47 702 1646 0.80 0.69 0.82 45 20
48 733 1658 0.79 0.70 0.82 45 19
49 764 1670 0.80 0.69 0.83 45 20
50 796 1682 0.79 0.72 0.82 44 19
51 829 1694 0.78 0.70 0.82 44 19
52 865 1705 0.80 0.69 0.81 45 20
53 908 1715 0.79 0.73 0.80 44 19
54 953 1725 0.78 0.72 0.79 44 18
55 999 1734 0.78 0.71 0.79 44 18
56 1046 1742 0.77 0.73 0.78 44 17
57 1096 1750 0.76 0.73 0.76 43 16
58 1151 1758 0.75 0.73 0.78 42 15
59 1206 1765 0.74 0.72 0.78 42 14
60 1272 1772 0.74 0.73 0.76 41 13
61 1353 1779 0.74 0.74 0.76 42 14
62 1434 1785 0.76 0.74 0.76 43 16
63 1515 1791 0.75 0.74 0.75 42 15
64 1597 1797 0.74 0.71 0.74 42 14
65 1695 1802 0.72 0.71 0.72 40 11
66 1807 1807 0.71 0.71 0.71 40 10

Notes:
a
Mean portfolio risk as a percentage of the mean risk of a single MSA.
b
Percentage of portfolio risk not eliminated by diversification.

property type sub-indices are used for the analysis.
That is, for each of the thirty largest MSAs, there
is an index for each property type within that
MSA. From a certain angle, this is actually a way
of intra-city diversification. Previous studies have
shown that diversification within a city can reduce
portfolio risk. Rabianski and Cheng (1997) dem-
onstrate that properties located in different areas
of four major cities exhibit low or negative corre-
lation, indicating possible diversification benefits.
Wolverton, Cheng, and Hardin (1999) show intra-
city diversification can be achieved within the
apartment market of Seattle. Intra-city diversifi-
cation can be carried out in two ways, by submar-
kets and by property types. The analysis discussed
here chooses the latter.
The results of the analysis are presented in Ex-
hibit 6. Comparing with the ‘‘Large MSA Only’’
scheme, the results are very similar in terms of
mean portfolio risk and percentage of risk not
eliminated by diversification. Exhibit 7 illustrates
relationship between portfolio risk and portfolio
size. The mean portfolio risk of ‘‘Large MSA Only’’

36 Vol. 13, No. 1, 2007

 Measuring the Effectiveness of Geographical Diversification

Exhibit 3
Effects of Diversification: ‘‘Mixed MSA’’ Scheme

scheme is also plotted for comparison purpose.
Clearly, the mean portfolio risks of both schemes
are within the 95% confidence interval, indicating
there is no statistical difference between them. Ex-
hibit 8 plots the Ks for the three schemes. The
curves of the ‘‘Large MSA Only’’ scheme and the
‘‘Simultaneous’’ scheme track each other fairly
closely, whereas the curve of the ‘‘Mixed MSA’’
scheme lies below the other two curves. The obvi-
ous conclusion is that the ‘‘Mixed MSA’’ scheme is
the most effective in reducing portfolio risks close
to the minimum achievable risk. The other two
schemes do not differ significantly in their Ks. This
is not surprising because the aggregated MSA in-
dices used in the ‘‘Large MSA Only’’ scheme are
nothing more than the average of property type
sub-indices used in the ‘‘Simultaneous’’ scheme. In
other words, the ‘‘Large MSA Only’’ scheme actu-
ally implicitly considers by-sector diversification,
which is explicitly considered by the ‘‘Simultane-
ous’’ scheme. So does it mean that there is no ben-
efit to be gained from intracity, by-property type
diversification? Not exactly. Although for a given
portfolio size, there are no significant differences
between the portfolio risks or risk reduction, the
‘‘Simultaneous’’ scheme usually covers a less num-
ber of MSAs. For example, whereas the ‘‘Large
MSA Only’’ scheme requires diversification across
thirty MSAs to achieve a K of 40%, the same may
be achieved with only thirty property type sub-
markets in only a few MSAs. Given the fact that
investing in real estate requires localized market
knowledge, which is often expensive to acquire, if
the similarly diversified portfolios can be achieved
without having to go into too many different cities,
so much the better. In other words, intracity di-
versification can be beneficial to investors to the
extent that it is less costly to implement.
The ‘‘Large MSA by Property Type’’
Scheme
This scheme examines the risk reduction capabil-
ities of various property types within the thirty

Journal of Real Estate Portfolio Management 37

Ping Cheng and Stephen E. Roulac

Exhibit 4
Portfolio Risk Reduction by Diversifying among the 30 Largest U.S. Cities
Number of Properties 95% Confidence Interval of Portfolio
Contained Risks
Number of Mean Portfolio
MSAs Minimum Maximum Risks (%) Lower Bond (%) Upper Bond (%) Ba Kb

(1) (2) (3) (4) (5) (6) (7) (8)

1 8 112 1.64 0.81 3.08 100.00 61

2 20 210 1.41 0.78 2.04 85.70 54
3 33 292 1.32 0.74 1.81 80.21 51
4 47 373 1.28 0.73 1.87 78.11 50
5 62 439 1.24 0.86 1.73 75.43 48
6 78 494 1.27 0.92 1.64 77.38 50
7 95 544 1.22 0.87 1.69 74.32 47
8 113 591 1.20 0.85 1.60 72.99 46
9 132 637 1.17 0.95 1.49 71.53 45
10 152 682 1.16 0.95 1.43 70.98 45
11 173 725 1.18 0.92 1.47 72.21 46
12 195 761 1.20 0.93 1.42 72.85 46
13 218 794 1.19 0.99 1.35 72.25 46
14 244 826 1.19 0.97 1.35 72.65 46
15 271 857 1.23 1.05 1.32 74.69 48
16 302 884 1.22 1.07 1.34 74.09 47
17 334 910 1.24 1.08 1.30 75.80 48
18 367 933 1.23 1.10 1.29 74.69 48
19 403 955 1.21 1.15 1.27 73.48 47
20 446 976 1.19 1.12 1.26 72.34 46
21 491 996 1.21 1.09 1.25 73.75 47
22 537 1015 1.19 1.07 1.25 72.78 46
23 584 1033 1.17 1.04 1.24 71.55 45
24 634 1050 1.17 1.09 1.20 71.55 45
25 689 1066 1.19 1.06 1.21 72.73 46
26 755 1081 1.18 1.10 1.19 71.62 45
27 836 1095 1.15 1.08 1.16 69.89 44
28 918 1108 1.10 1.04 1.10 67.04 42
29 1016 1120 1.08 1.08 1.11 66.07 41
30 1128 1128 1.12 1.12 1.12 68.19 40

Notes:
a
Mean portfolio risk as a percentage of the mean risk of a single MSA.
b
Percentage of portfolio risk not eliminated by diversification.

largest MSAs. Five types of properties are exam- types of properties exhibit very different risk re-
ined and the Ks of each property type are sum- duction abilities. According to the results, apart-
marized in Exhibit 9 and graphically presented in ments and retail properties are the best diversi-
Exhibit 10. The obvious result is that different fiers while office is the poorest diversifier. An

38 Vol. 13, No. 1, 2007

 Measuring the Effectiveness of Geographical Diversification

Exhibit 5
Effects of Diversification: ‘‘Large MSA Only’’ Scheme

apartment portfolio of fifteen properties can elim-
inate nearly 90% of the diversifiable risk, but the
same size office portfolio can only eliminates about
36% of the diversifiable risk. This result suggests
that apartment properties across the large MSAs
are less alike than that of office and industrial
properties, thus offering better diversification op-
portunities. Therefore, investors should allocate
more capital in apartments and less on office and
industrial for better diversification. The current in-
stitutional practice, however, seems to indicate just
the opposite. Worzala and Bajtelsmit (1997) re-
ported that pension fund real estate portfolios on
average allocate 32.3% to office, 33% to retail, and
17% to industrial. But they only allocate 10.8%
to apartments. Shilton and Stainley (1995) also
showed that the apartment sector is the least rep-
resented sector in the NCREIF database. While
the retail sector seems to exhibit the second best
diversification ability, their performance for the
study period, as shown in Panel B of Exhibit 1, is
the poorest sector, which raises questions as to
why institutional investors choose to allocate one-
third of their portfolio in this sector. In addition,
there is the question of whether it is justified to
allocate heavily to the office and industrial sectors.
How Affective is Geographic
Diversification?
So far, the findings seem to suggest that the ef-
fectiveness of geographic diversification is limited.
To eliminate the diversifiable risk of real estate
portfolios requires investing in many different
MSAs and potentially a large number of proper-
ties. As indicated in Exhibits 2, 4, 6, and 9, the
marginal risk reduction from expanding diversifi-
cation to more MSAs declines rather quickly, and
become very small beyond ten to fifteen MSAs. On
one hand, this explains why institutional portfolios
tend to be geographically concentrated. On the
other hand, it also implies that diversifiable risk
remains a large portion of a portfolio’s total risk.

Journal of Real Estate Portfolio Management 39

Ping Cheng and Stephen E. Roulac

Exhibit 6
Portfolio Risk Reduction by Diversifying Simultaneously by City and by Property Type among the
30 Largest U.S. Cities
Number of Properties 95% Confidence Interval of Portfolio
Contained Risks
Number of Mean Portfolio
MSAs Minimum Maximum Risks (%) Lower Bond (%) Upper Bond (%) Ba Kb

(1) (2) (3) (4) (5) (6) (7) (8)

1 4 67 2.49 0.91 5.31 100.00 74

2 9 125 1.93 0.85 3.53 77.53 67
3 15 180 1.72 0.85 3.32 69.11 63
4 22 231 1.62 0.88 3.14 65.18 61
5 30 276 1.49 0.87 2.87 59.89 57
6 39 319 1.44 0.80 2.62 57.95 56
7 49 359 1.39 0.82 2.32 55.96 54
8 60 393 1.33 0.79 2.25 53.49 52
9 72 426 1.30 0.83 2.10 52.09 51
10 85 455 1.31 0.79 2.14 52.65 51
11 99 483 1.25 0.81 2.10 50.11 49
12 114 510 1.24 0.78 1.91 49.95 48
13 130 536 1.21 0.76 1.78 48.45 47
14 147 561 1.22 0.81 1.76 49.03 47
15 165 585 1.17 0.81 1.70 46.98 45
16 184 608 1.17 0.80 1.61 47.19 45
17 204 630 1.15 0.82 1.63 46.08 44
18 225 651 1.16 0.81 1.66 46.80 45
19 247 671 1.14 0.81 1.50 45.86 44
20 270 690 1.14 0.78 1.48 45.70 44
21 294 708 1.12 0.79 1.46 45.05 43
22 319 725 1.13 0.79 1.50 45.28 43
23 345 741 1.12 0.78 1.44 44.85 43
24 372 756 1.11 0.80 1.38 44.51 42
25 400 770 1.11 0.80 1.44 44.49 42
26 429 783 1.09 0.79 1.35 43.70 41
27 462 795 1.10 0.80 1.32 44.18 42
28 496 806 1.09 0.79 1.30 43.78 41
29 536 816 1.07 0.78 1.28 43.04 40
30 579 825 1.07 0.78 1.28 43.02 40

Notes:
a
Mean portfolio risk as a percentage of the mean risk of a single MSA.
b
Percentage of portfolio risk not eliminated by diversification.

For example, when diversifying across all thirty of
the largest MSAs, diversifiable risk remains as
high as 40% of the portfolio’s total risk. This is
largely because markets of large MSAs tend to
move in the same directions; that is, they are more
positively correlated. The effectiveness is not im-
proved with the ‘‘Simultaneous’’ scheme, although
it may allow the same diversification effect to be
achieved with a smaller number of MSAs. Even
with the more effective scheme, the ‘‘Mixed MSA’’
scheme, Exhibit 2 suggests that, to reduce the di-
versifiable risk to about 10% of a portfolio’s total
risk, investors would have to invest in at least
sixty-six MSAs, an impossible task for virtually

40 Vol. 13, No. 1, 2007

 Measuring the Effectiveness of Geographical Diversification

Exhibit 7
Effects of Diversification: ‘‘Simultaneous’’ Scheme

Exhibit 8
Comparison of the Effectiveness of the Three Diversification Schemes

Journal of Real Estate Portfolio Management 41

Ping Cheng and Stephen E. Roulac

Exhibit 9
‘‘Large MSA Only’’ Scheme for Various Property Types
Percentage of Portfolio Risk Not Eliminated by Diversification (K)

MSAs in the Portfolio Apartment Industrial Office Retail Warehouse

1 63.00 71.39 78.81 70.42 68.66

2 51.02 65.75 75.16 62.50 60.73
3 43.40 62.13 73.20 56.70 54.67
4 36.93 58.87 70.89 51.70 51.03
5 31.35 55.52 70.07 47.57 47.30
6 27.39 54.61 68.55 42.50 46.05
7 23.09 51.76 68.10 39.56 43.95
8 20.53 50.87 66.60 37.84 39.37
9 18.70 49.93 66.09 34.74 38.93
10 16.10 48.65 65.50 31.62 37.07
11 12.97 47.71 65.35 30.77 35.29
12 11.20 46.43 64.95 28.62 35.40
13 10.70 44.81 65.34 27.79 33.80
14 12.16 46.82 64.69 28.01 33.11
15 10.32 45.63 64.20 27.68 34.42
16 8.12 45.15 64.74 27.71 35.70
17 5.38 45.39 65.58 27.38 37.74
18 4.72 45.21 65.05 26.19 35.83
19 4.81 45.41 64.91 28.80 34.76
20 2.85 45.45 64.79 27.04 37.53
21 1.39 44.31 64.05 26.23 37.95
22 1.12 44.07 63.80 25.78 36.52
23 2.82 43.58 64.05 27.35 36.05
24 3.21 42.65 64.24 24.48 35.68
25 0.33 41.80 64.39 22.42 35.47
26 2.94 41.38 63.97 24.04 37.07
27 2.26 40.24 63.55 21.34
28 3.98 40.45 63.79 21.45
29 2.77 42.12 63.56 22.02
30 3.57 43.30 63.59 22.70

any institution. This is consistent with Young and
Graff (1995) who suggested that it takes nearly all
the NCREIF properties to eliminate nonsystematic
risks. Thus the dilemma: On one hand, inves-
tors should not diversify across too many MSAs
because the marginal risk reduction dimin-
ishes quickly; on the other hand, geographically-
concentrated portfolios may be severely under-
diversified in the sense that they contain high div-
ersifiable risks, and it is questionable whether the
returns of those portfolios sufficiently compensate
investors for taking the risks.

42 Vol. 13, No. 1, 2007

 Measuring the Effectiveness of Geographical Diversification

Exhibit 10
Effectiveness of Geographic Diversification for Different Types of Properties
90

80

70
Office
Percent of Risk Not Diversified Away

60

50
Industrial

40
Warehouse

30
Retail

20

10
Apartment

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Number of MSAs in a portfolio

Conclusion The findings also suggest that different types of

properties exhibit different effectiveness in geo-
This study investigates the effectiveness of geo-
graphic diversification. Apartments, a sector that
graphic diversification across the U.S. metropoli-
has historically attracted less institutional atten-
tan areas. Four diversification schemes, the
‘‘Mixed MSA,’’ ‘‘Large MSA Only,’’ ‘‘Simultaneous,’’ tion, turns out to be much more effective for geo-
and ‘‘Large MSA by Property Type,’’ are analyzed. graphic diversification than the traditional insti-
The effectiveness of diversification is measured by tutional investors favor, such as the office and
the ratio of portfolio risk to the average risks of industrial sectors. This suggests that institu-
single assets (the B), and by the proportion of port- tional investors rethink their asset allocation
folio risk that is not eliminated by diversification strategy and pay more attention to the apartment
(the K). In general, the findings suggest that the sector.
effectiveness of geographic diversification should
not be over estimated. The marginal risk reduc- The notion that geographic diversification provides
tion from expanding into more cities diminishes limited risk reduction for real estate portfolios has
quickly, making the choice of staying geographi- at least two important implications. First, unlike
cally concentrated a sensible portfolio strategy. Yet investing in the securities markets, where portfolio
it is also a risky strategy that may subject portfo- performance is largely determined by asset allo-
lios to rather high diversifiable (nonsystematic) cation than security picking, in the real estate
risks. It would be an important extension of the market, asset allocation with regard to geographic
current study to investigate the actual institu- diversification should not replace property level
tional portfolios to see whether they are indeed decisions. Investors due diligence plays an irre-
subject to nonsystematic risks and whether their placeable role and has significant impact on port-
returns sufficiently compensate investors for tak- folio performance. Second, if it takes a large num-
ing the risk. ber of properties in a large number of cities to

Journal of Real Estate Portfolio Management 43

Ping Cheng and Stephen E. Roulac
achieve optimal diversification, then it is practi-
cally an impossible task for even the largest insti-
tutional investors. The only possible way to accom-
plish that type of diversification in real estate,
therefore, may be through asset securitization. The
past decade has seen growing institutional interest
in REITs (Chan, Leung, and Wang, 1998), yet the
number of REIT-owned properties is still a very
small portion of the entire property market. Hope-
fully, future studies will discover more evidence
consistent with the findings of this study. This ev-
idence will challenge conventional thinking and
stimulate institutional interest in REITs and other
types of securitization.
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