Ife Journal of Environmental Design and Management Vol.

5, August, 2011

PROPERTY PORTFOLIO DIVERSIFICATION STRATEGIES: A

REVIEW OF THE OPTIONS.

Abel Olaleye
Department of Estate Management, Obafemi Awolowo University,
Ile – Ife, Nigeria

Abstract:
The area of property portfolio diversification and performance analysis of
property investments has received a great deal of attention in the financial and
economics literature especially in the developed economy when compared to
property investment analysis and decisions in the developing world. In view
of the need to improve the knowledge of stakeholders in the Nigerian property
market with a view to ensuring specialist services and assurance of best
practices in diversification decisions, this paper reviewed the various options
available to investors when thinking of diversifying within real estate
portfolio. Directions for within real estate portfolio diversification were thus
highlighted.

15
 Ife Journal of Environmental Design and Management Vol. 5, August, 2011
Introduction
In recent time in Nigeria, the pattern of
investment in real estate has changed
substantially like in many parts of Africa
and the world. In the last decade and a half,
the property investment market has become
dominated by major organisations and
institutional investors such as Wemabod
Estate, UAC Property Development
Company, Stallion Properties, Churchgate
Development Company, Honeywell
Properties, Insurance Companies and a host
of public Property Development
Corporations. Within the same period, the
match towards integrating real estate
market into the capital market started with
the listing of UACN Properties in the
Nigerian Stock Exchange. This is coupled
with the recent establishment of Skye
Shelter Fund and Union Homes Hybrid
REITs in 2007 and 2008 respectively and
the subsequent listing of Skye Shelter Fund
at the floor of the Nigerian Stock Exchange
in February, 2008.
The corollary of the foregoing is
that the drive towards indirect ownership as
well as securitisation and unitisation is
gradually dominating the property market.
This development is signalling the
obsolescence of the old two-party real
estate deal, and the emergence of large
numbers of passive owners of real estate
securities and investors. The development
has also increased investors awareness and
most of them are now treating their
investments in property as a significant
proportion of their total assets and are now
demanding a higher degree of professional
expertise from practitioners (Olaleye and
Ajayi, 2004). This trend is also expected to
continue and has greater momentum with
the recent pension reform by the Federal
Government which is sure to create access
to a large long-term pool of fund that can
be invested in the property sector.
16
With these increasing activities and
sophistication of market players coupled
with the prevalence of risk and
uncertainties in the Nigerian property
market, the major issue that will be of
concerns to both the investors and advisers
is how best one can diversify within real
estate sector to achieve the best return/risk
performance. However, it appears that the
property market in Nigeria has not only
been unable to keep pace with trends in the
U.K., Australia, USA and other developed
countries, in the area of property portfolio
diversification, but also has maintained a
non-responsive outlook to the new
challenges. The market has been generally
slow in accepting a wide range of the
quantitative techniques involved in
portfolio diversification and management
but rather prefer qualitative techniques
(Olaleye, 2000, 2005). Finding reasons for
this development, Olaleye, et al (2007) and
Olaleye (2008) suggest that practitioners’
low level of knowledge and training in
quantitative techniques of diversification
have been the major factors. Meanwhile,
there is compelling evidence (Mueller,
1993; Cheng and Liang, 2000; Olaleye and
Aluko, 2007 and Olaleye et al, 2008) to
suggest that qualitative (naïve) techniques,
most times, did not lead to best portfolio
selection and as such failed to provide best
protection against the prevailing risk in any
property market. In addition, portfolio
diversification study is still in its infancy in
Nigeria and as such very few studies exist
in this area.
In view of the need for efficient
decision in property portfolio
diversification therefore, there is the need
for investors and advisers alike to be
familiar with and knowledgeable in the
theory and methodology used and accepted
in other investment media. Towards
achieving this fit, there is need to address
 Ife Journal of Environmental Design and Management Vol. 5, August, 2011
the question of what diversification
strategies are available as options for
investors when thinking of diversifying
within real estate. This paper provides an
avenue for bridging these observed lapses
and highlights new directions for property
portfolio diversification in Nigeria. The
remainder of the paper is structured into
two main sections. The first section
provides the theoretical base on the concept
of naïve and Modern Portfolio Theory
(MPT) based portfolio diversification;
discusses the basic approaches to
diversification of portfolio investment and
gives an insight into the factors that
influence the choice of a diversification
strategy. The second section concludes.
Concept of Property Portfolio
Diversification
Since time immemorial, investors
have approached the problem of investment
decisions in a number of ways. Some prefer
the strategy which according to Hargitay and
Yu (1993) was formulated by Andrew
Carnegie, whose maxim says “put all your
eggs in one basket and then watch the
basket”. The dictum “do not put all your
eggs in one basket” appears to be the belief
of many. This is with the belief that risk of
loss can be minimised by not putting all of
one’s assets in “one basket”. The theory of
portfolio diversification gives a precise
meaning to this later idea.
Portfolio diversification can thus be
described as the technique of varying
investment possibilities in order to minimise
the encompassed risks and maximise the
return therefrom. It describes the
combination of investments/securities within
the same asset class. Thus, diversification
achieves the same objectives as asset
allocation (the selection of a portfolio of
investments where each component is an
asset class rather than an individual security)
that is maximising return with minimum
17
risk. However with diversification, the
concern is with reducing the specific or
unsystematic risk, while asset allocation
focuses on reducing the systematic risk.
However, since property market is localised
and products are heterogeneous; real estate
market place is an amalgamation of a least
hundred, if not thousands, of specific market
segments that have their own conditions,
problems and opportunities. Thus,
diversification as used in this paper is
relevant to the concept of minimising the
systematic and unsystematic risks within
real estate investment market.
A wide range of portfolio
diversification approaches can be identified.
These range from a simple rule of thumb to
full-scale quantitative techniques.
Meanwhile, the various approaches to
portfolio diversification and allocation are
divided into two main categories. (Hadaway,
1978; Hargitay and Yu, 1993; Cheng and
Liang, 2000; Sing and Ong, 2000 and
Olaleye, 2005). The first is the one usually
referred to as traditional approach or naive
diversification, which simply looks at
investor’s objectives in terms of the need for
income and/or capital appreciation and then
selects those assets/securities which appear
to be the most appropriate to meet these
needs. The other approach is based on MPT.
Fig. 1 gives a schematic diagram of the
concept of property portfolio diversification
discussed in the subsequent sections of this
paper.
 Property Portfolio Diversification

Naïve Diversification or Modern Portfolio theory

Traditional Approach based diversification

Geographic/ Property Managers Timing / life Lease Investment Investment vehicle

Economic Type Diversification cycle Diversification structure (ownership pattern)
Diversification div. Diversification Diversification Diversification

Manager
A mix of properties at
Regional different completion
level stages or cycles Equity Debt
National A B C financing financing
Sub-market level
level

Tenant mix Short lease Long lease Individual Partnership Joint

Mix of ownership ownership
different
Different Different property
Sectoral property classes of
mix type of same same type Developed and
sector undeveloped Mean variance Capital Asset
Analysis Pricing model

Sharpe Index Constant

Model Correlation

No short sale (assets are held

Short sale allowed long)

Fig 1. A Schematic Diagram of the Concept of Property Portfolio Diversification

Source: Author’s Review.
Naive Diversification Strategies
Naive diversifications, otherwise
called traditional portfolio selection
strategies, involve the use of conventional
wisdom, rule of thumb and intuition in
making selection and management
decisions. According to Hadaway (1978)
and Hargitay and Yu (1993) with naïve
portfolio diversification, activities were
regarded as an art, where intuition and
‘feel’ dominated decision-making. Such
diversification strategies, according to
these authors, are directed towards the
maximisation of current income or the
achievement of capital gains in the future.
In these strategies, the most sought-after
asset is a common stock with high current
income and with low risk profile as well as
securities which have a high return and
low-risk profile relative to the market. Part
of the approaches to the minimisation of
risk is to attempt a continuing balancing act
between risk-free securities such as gilts
and treasury bills and equities with higher
risk profile matched by greater growth
potential (Hargitay and Yu, 1993). The
success of this method is however hinged
on a continuing monitoring and analysis of
the behaviour of the market and interest
rates.
Generally however, “within real
estate diversification” has traditionally
been studied along two dimensions,
namely, geographic grouping and property
types. (Hadaway, 1978; Del Casino, 1995;
Mueller and Louargand, 1995; Williams,
1996; and Cheng and Liang, 2000;
Olapade, 2002; Lee, 2005; Adair, et al,
2006 and Olaleye et al, 2008). These
authors have demonstrated that
diversification benefits may be captured by
diversifying into geographic location or
different property types or using both
strategies. This suggest that investors have
basically two choices (strategies) in
property portfolio diversification; that is,
the geographic/economic and property type
diversification.
Geographic/Economic Diversification
Geographic/Economic
diversification is the combination of
different classes of real estate assets in
different locations. The method is based on
the idea that the returns and risks of real
estate investments vary according to their
locations, even if all other aspects, such as
transaction structure, property type and size
are similar. In adopting this method,
investors need to consider the challenges
and opportunities inherent in various
geographic regions as well as considering
the advantages of particular metropolitan
areas/regions and cities. A traditional
approach for defining geographic regions
in United States of America, according to
Del Casino (1995), is in terms of Northeast,
South, Midwest, and West. Other
approaches use a socio-economic
dimension: the Energy Belt (the heavy
manufacturing Midwestern States), the
Rust Belt e.t.c. Other considerations, in
terms of metropolitan areas and cities,
according to this author, are with respect to
a variety of characteristics such as old
cities versus new, growing cities versus
declining ones, large cities versus small
ones, eastern versus western cities, cities
with restrictive zoning policies versus those
without zoning policies, dense cities versus
sprawling ones and so forth.
Geographic diversification is often
pursued on a variety of levels, including
national, regional, metropolitan areas, and
even smaller spatial definitions. (Del
Casino, 1995; Williams, 1996; Cheng and
Liang, 2000). Del Casino (1995), for
example, suggests that international
investors often fulfil their
economic/geographic diversification
requirements at a national level by making
investments in a few large cities of a
particular nation, irrespective of the extent
to which the cities represent national
economic trends. Domestic investors view
diversification on a much smaller scale,
and some have a particular regional
orientation and diversify by placing
investments in a variety of metropolitan
areas. Other investors with a much broader
perspective diversify at the state or regional
market levels and others with a narrower
perspective diversify at the sub-market or
local market levels. However, investors
should plan to diversify their investments
with respect to geographic and regional
economic vulnerabilities and opportunities.
In other words, effective
geographic/economic diversification results
from selecting investments in areas that
have fundamentally different economies, as
against focussing on the basic geographical
regions of a nation.
Property Type Diversification
Property type diversification,
according to Penny (1982), involves
investing in various types of property such
as shopping centres, offices, warehouses,
factory buildings, residential/apartments
and hotels. Like geographic/economic
diversification, diversification by property
type is usually attempted on several levels.
Some investors diversify their real estate
holdings at the broadest level by selecting a
mix of residential and non-residential
properties or a mix of developed and
undeveloped real estate holdings. Others,
especially institutional real estate investors,
usually diversify at a more detailed level by
differentiating among basic business
categories such as office, industrial,
shops/retail and hotel uses. Investors who
deal in only one particular business
category, such as office, retail or industrial
can diversify based on regional or local
markets they serve and the products they
sell. For example, office property investors
sometimes distinguish between downtown
high-rise properties and sub-urban business
parks as well as different quality classes of
properties. Industrial property investors
often differentiate among light and heavy
manufacturing facilities, warehouses and
distribution plants. (Del Casino, 1995).
The basis of property
diversification is that returns and risks vary
according to the particular industries
utilising various types of property. For
example, office property generally
responds to the needs of the financial and
services-producing sectors; industrial
property to the goods-producing sectors;
shop property to the retail sector; and
hotels to the travel and tourism sectors,
employment growth, and the business
cycle. As such, adopting property type
diversification requires understanding of
the factors affecting each property type’s
user groups and investors should be aware
of the range and variety of characteristics
attributable to each category (Roulac,
1996).
In addition to the above
diversification strategies, authors such as
Cheng and Liang (2000), Del Casino
(1995) and Olaleye and Aluko (2007) have
discussed other strategies, which have
received considerable attention from some
investors in recent times. These are:
managers diversification, lease
diversification, timing (life and investment
cycle), investment structure and investment
vehicle diversification. These are discussed
in the next section.
Managers Diversification
This diversification involves
investing in various property types based
on the differing managerial skills. The need
for managers diversification derives from
the fact that the varying skills and
experiences possessed by various property
managers can have great effects on the
performance of a particular property in
terms of the risk-return trade-off. Thus,
Cheng and Liang (2000) reported that
pension funds in United States of America
have been advised to seek diversification of
managers and property types.
Timing: Investment/Life Cycle
Diversification
Investors often combine
investments on the basis of holding period
and property life cycle to reduce the risk of
their inability to time markets. In other
words, timing or investment life cycle
diversification, otherwise called holding
period diversification (Cheng and Liang,
2000), involves combining investments that
are at different stages of their life cycle.
This, in the opinion Del Casino (1995), is
borne out of the fact that a real estate
investment’s return and risk change as it
moves through an investment holding
period cycle and through the various phases
of the life cycle: planning, acquisition, pre-
development, development, financing,
leasing, management and ultimately
disposition. For example, real estate
acquired during the development stage may
involve environmental risks relating to land
use regulations, zoning ordinances,
infrastructural regulations and physical
risks associated with new construction,
such as labour strikes, construction material
shortages, vandalism and so forth. In the
alternative, properties acquired upon
completion may involve only financing and
marketing risks.
Lease Diversification
Lease structure diversification
involves diversification of tenant mix in
terms of credit quality (rating) and business
as well as lease length or maturity. This
diversification method, according to Del
Casino (1995), can be an effective strategy
for minimising a property’s or portfolio’s
operating risks and has received
considerable attention from some investors.
Tenants’ credit ratings and businesses are
often evaluated in terms of some yardsticks
such as tenants’ income and regularity or in
relation to indices on businesses and debts
of the lessees, where applicable. Leases are
compared with regards to their length
(including renewal options) which may
vary considerably, and investors’ attitudes
towards lease length are often influenced
by the market cycle. Roulac (1996) opined
that, in a rising market, investors prefer
shorter leases (which provide an
opportunity for tenant renewals at higher
rents), while in falling markets, they prefer
longer leases, (which provide some
downside protection).
Investment Structure Diversification
Investment structure usually relates
to how an investor combines equity and
debt in capitalising a transaction and, as a
result, usually affects the position of the
investor in terms of his rights,
responsibilities and risks with respect to an
investment (Pagliari and Garrigan, 1995).
The decision to choose investment
structure diversification (combining equity
and debt financing) in real estate
investment is borne out of the fact that
several real estate investment structures
that are in the same geographic market and
similar in property type might exhibit very
different return performances and risk
profile. In addition, risks associated with
investment options may be diversified
away in parts. This is so because, while an
asset’s mortgage part would be vulnerable
to interest rate, inflation, and default risks
and perform strictly as a fixed-income
investment; its equity part might provide an
effective inflation hedge but be vulnerable
to certain business risks; and its convertible
mortgage would perform as a hybrid,
showing returns and risks characteristic of
each “pure” form of investment. Thus, of
important consideration when diversifying
a real estate portfolio according to
investment structure, is the percentage
allocation of the overall portfolio to other
classes of investment in the market.
Investment Vehicle Diversification
This approach, which is similar to
investment structure diversification, has
more to do with how the real estate is
owned by investors than the real estate
itself (i.e. its financing). The term
“investment vehicle” refers to the
ownership format of an investment. That is,
whether a property is owned individually,
as a partnership, as a corporation, or some
other form such as indirect ownership.
While direct ownerships usually offer
investors the greatest potential returns, they
usually expose them to greatest risks. More
passive ownership, such as that achieved
through private real estate limited
partnerships, limits the business liability
risks attendant to real estate investments,
but also limits the investor’s participation
in management decisions. Extremely
passive ownership formats, such as
publicly traded real estate investment trusts
and real estate mutual funds, reduce the
liquidity risks associated with real estate,
but preclude investors from individually
managing their investments to suit their
own financial objectives. (Del Casino,
1995).
Modern Portfolio Theory Based
Diversification
Modern Portfolio Theory and
quantitative diversification concept was
pioneered by Markowitz (1952, 1959) who
laid the foundation for the rational
approach to the selection, analysis and
management of investment portfolios.
Since Markowitz works however, other
authors such as Sharpe (1963, 1964), have
examined possible ways of diversifying
within the stock market although two
decades elapsed before MPT was first
applied to real estate (Elton et al., 2010;
Reilly, 1994; Dubben and Sayce, 1991;
Mueller, 1993; Sanders, Pagliari and
Webb, 1995). The MPT methods involve
holistic approach to diversification and
they are aimed at creating strategies which
maximises the expected returns on a
portfolio for a specified level of risk. As
shown in Figure 1, two basic methods
under MPT based diversification are
discussed in this paper; that is, Markowitz
Mean Variance Analysis (MVA) and
Capital Asset Pricing Model (CAPM) that
is, Sharpe Index Model (SIM).
Markowitz Mean Variance Model
Markowitz’s (1959) model
demonstrated how risk might be reduced
within a portfolio by combining assets
whose returns demonstrated less than
perfect positive correlation. In other words,
MVA gives precise mathematical meaning
to the adage “don’t put all of your eggs in
one basket”. The method is based on the
argument that the focus on maximising
expected return is not a sufficient portfolio
consideration but rather, the return and
variance (risk) of assets must be considered
in combination. The theory requires a
number of conditions that investors are
assumed to conform with. These include:
1. Investors consider each
investment alternative as being
represented by a probability
distribution of expected returns
over some holding period.
2. Investors estimate risk on the
basis of the variability of expected
returns.
3. Investors base decisions solely on
expected returns and risk, so their
utility curves are a function of
 expected return and variance (or
standard deviation) of returns
only.
4. For a given risk level, investors
prefer higher returns to lower
returns. Similarly, for a given
level of expected return, investors
prefer less risk to more risk.
5. All capital assets are infinitely
divisible, so that parts of an asset
can be bought.
6. All assets, including human
capital, are marketable.
7. All information is free and
simultaneously available to
investors. (Elton, et al., 2010).
Following the procedure outlined by
Markowitz (1959), the optimal
combination of portfolio weights can be
determined based on the return, variance
and the correlation coefficient for each
asset in the portfolio. This procedure thus
requires three types of information: (1) The
rate of return from individual assets that
constitute the portfolio; (2) a measure of
the way each asset dispersed around its
expected return value (its risk measured by
variance) and (3) expected covariance for
each pair of assets in the portfolio. This is
so because to measure portfolio risk level,
not only is it necessary to know the
expected return together with a measure of
risk of the constituents assets, but it is also
important to know how the returns move in
relation to each other over a period i.e. their
correlation coefficient or covariance. The
essence of this is that for diversification to
be meaningful, investments must react
differently to outside influences, or in
statistical language, they must be
negatively correlated. If this happen, when
the expected rate of return for asset A, for
example, is high, it is counterbalanced by a
low rate for asset B. In this way, combining
A and B into a portfolio has the effect of
eliminating much of the risks. Therefore
when two assets have good and poor
returns at opposite times, an investor can
always find some combination of these
assets that yields the same return under all
market conditions.
Given the return and risks of
individual assets, the return on a portfolio
or sector (depending on whether one is
involving ex-post or ex-ante analysis) is
computed as the weighted average of the
returns on its components or individual
assets. The weight applied to each return is
the fraction of the portfolio invested in that
asset. Thus, if Rp is the return on the
portfolio, Xi is the fraction of the investor’s
funds invested in asset i and r i the return
from asset i, then:
 Rp = .......................................................................... (1)

That is, Rp = X1r1 + X2r2 + ..............+ Xiri .....+ Xnrn .................................... (2)

The portfolio expected return is also a simple weighted return of each asset’s expected return
multiplied by its weighting in the portfolio. That is:
E(Rp) = .......................................................................... (3)

Where E(Rp) = Expected return on the multiple asset or portfolio

= Percentage of the portfolio invested in the ith asset and
= Expected return on the ith asset.

The profile of historic risk exposure of an investment portfolio can be obtained using the
relationship similar to equation 1. That is, if K p is the portfolio risk and Xi the proportion of
the portfolio invested in ith asset by value, then:

Kp = X1K1 + X2K2+............. XiKi...........+XnKn ............................ (4)

Where Ki = the risk (Variance or Standard deviation) on asset i.

variance of a portfolio is a combination of

This relationship however, assumes that
there is a linear combination of the assets’
variances or that the portfolio returns are
perfectly correlated. (o,j = 1). Since assets’
returns are not expected to be perfectly
correlated, Markowitz proposed that the
the different assets’ variances, their
weighting in the portfolio and the
correlation/covariance of one asset’s
variance with that of another. (Elton, et al.,
2010 and Sanders, Pagliari and Webb,
1995). It is given in its general form as:

E (p2) = ...................................... (5)

Where E(p2) = Expected variance of the multiple-asset portfolio

E(i2) = Expected variance of assets i
E((I,j) = Expected covariance between the ith and jth assets = o,j i j
Note that covariance is the product of two deviations and o,j is the correlation between
assets.
In the case of a two-asset portfolio, the portfolio variance can be written as:

E(p2) = XA2 E(A2) + XB2 E(B2) + 2(AB XAXBAB) ....................... (6)

(See Elton, et al., 2010; Pandian, 2001 and Bhalla, 2007 for detailed discussion on
this).
 Having obtained the expected return
and the risk of individual investments to be
included in a portfolio, the portfolio
possibility set (return and risk combination)
can be determined, using equations (3) and
(5), from which the efficient frontier can be
delineated. This in theory involves plotting
of all conceivable combination of risky
assets in a diagram/graph since there are an
infinite number of possibilities that must be
considered. (Elton, et al., 2010; Dubben and
Sayce, 1991 and Sanders, Pagliari and
Webb, 1995). Not only must all possible
groupings of risky assets be considered, but
also all groupings must be considered in all
possible percentage compositions.
However, if one is to plot all possibilities in
risk return space, one could get a diagram
that looks clumsy and scattered. As such,
Elton, et al., (2010) suggest that one could
find a set of portfolio that offers a bigger
return for the same risk or offers a lower
risk for the same return since we know that
an investor would prefer more return to less
and would prefer less risk to more.
Following this, one would have identified
all portfolios an investor could consider
holding, while all other portfolios could be
ignored.
When this is done, the efficient set
or frontier consists of the global minimum
variance portfolio and the maximum return
portfolio. This set of portfolio represents
the trade off between risk and expected
return faced by an investor when forming
his portfolio. It is a concave function (line
of best fit) in expected return standard
deviation space that extends from the
minimum variance portfolio to the
maximum return portfolio (Elton, et al.,
2010). The portfolio that is eventually
selected will however depend on each
investor’s risk/return preference (whether a
risk averse or risk taker) which can be
represented by risk indifference curves.
(Elton, et al., 2010; Dubben and Sayce,
1991 and Ajayi, 1998). According to these
authors, each curve represents a “frontier”
of the highest acceptable level of risk for a
given return. The point at which an
investor’s appropriate risk indifference
curve touches the efficient frontier
represents the optimal portfolio for the
investor. In practice however, it is possible
to by pass the problem of determining the
indifference curves by defining a return or
risk objective and determining the optimum
portfolio to achieve that objective (Hoesli
and Macgregor, 2000).
Although, the technique (MVA)
outlined above looks simple, authors have
questioned its reliability due to the
considerable amount of mathematics
involved. From practical point of view,
there are not two but thousands of
investment opportunities from which to
construct a portfolio, and the proportions in
which each investment can be held are
generally variable. The calculations
therefore become extremely complex even
with computer aid. In addition, the basis of
combining only risky assets in portfolio
construction has been questioned by authors
such as Sharpe (1963) and Treynor (1965).
They argued that investors have come to
realised that risky assets could be combined
with risk free assets to obtain a better
portfolio that would be outside the efficient
frontier or set. As a result Markowitz’s
MVA has been developed and modified by
many academics largely in the U.K. and
USA. (See for example, Sharpe (1963);
Treynor (1965) Jensen (1968), Elton, et al.,
(2010), Brown (1983) and Hargitay (1985).
The results of these modifications and
developments have given rise to what has
become known as Capital Market Theory
and has been shown to have considerable
practical applications and is making a
significant impact on the theory of
investment appraisal and valuation (Brown,
1983). In the words of Dubben and Sayce
(1991), CAPM was developed as an
extension to, and simplification of the
Markowitz theory and its very simplicity
has probably been the reason for its
acceptance with reservations, by many
financial analysts.
Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model, as a
theory, evolved from Sharpe (1963, 1964)
works and is based on the realisation that it
was possible for an investor to construct a
better efficient portfolio which could lie
outside the Markowitz’s opportunity set.
That is, if an investor invested in a risk free
asset, such as government bonds in addition
to a risky portfolio lying on the efficient
frontier he could obtain a better portfolio
yet not lying on the efficient frontier. This
is unlike the original theory that takes
efficient portfolio to comprise of
investments with all displaying some
volatility of return.
Sharpe Index Model
Sharpe Index Model (SIM)
simplified the process of data inputs and
analysis by developing a variant of
Markowitz MVA. The model has three
major distinctions by introducing (1) the
concept of a risk-free investment, (2) a
notional market portfolio and (3) an
efficient market is assumed to exist. The
model assumed that the fluctuation in the
E(Ri) = Rf + {E(Rm) – Rf }i .........................................
Where E(Rm) = Expected mean return on the market portfolio
Rf = Risk free rate for period t
Bi = Sensitivity of the security’s systematic risk to the market portfolio risk
give as:
i = Cov(Rm x Ri)
Varm
value of stock/asset relative to that of
another do not depend on the characteristics
of those two assets alone. The two assets
are more apt to reflect a broader influence
that might be described as general business
or market conditions. This relationship
between securities/assets occurs only
through their individual relationships with
some index or indexes of business activity.
Therefore in addition to determining the
expected return and risk of individual
constituent assets of a portfolio, there is
need to include (1) estimates of the
expected return and variance of one or more
indexes of economic activity and (2)
covariance estimates (sensitivity) for each
asset relative to the market index measure
as Beta.
Sharpe (1964) believed that the
return on any risky security would equal a
linear combination of the risk-free rate of
interest plus the sensitivity of the security’s
systematic risk to the market portfolio risk
as shown in equation (7). The linear
relationship, which is demonstrated by the
Capital Market Line (CML), is important as
it shows that as the rate of return on a
portfolio increases, it should be
compensated by a linear increase in risk, if
it is to remain in equilibrium with the
market (Brown, 1983). Sharpe (1964)
considered the expected return for each
asset to be:
(7)
or i = im/m2
.............................................. (8)
 m2 = the variance of the market index

Cov(Rm x Ri) or im = Covariance between asset I and the market portfolio

Regarding risk, the method assumes
that the total risk components of a portfolio
are divided into two: systematic and the
unsystematic risk components and that the
unsystematic risk component can be
eliminated by diversification (Elton, et al.,
2010, Brown. 1983 and Pandian, 2001).
Thus, it is not the total risk of the asset’s
returns that matters but how the asset’s
returns are correlated with the returns on
the market portfolio. That is, it is the
systematic risk component of the asset that
assumes major importance. The total risk
(variance) of an asset is given as:

 i2 = i2m2 + ei ……………………………………………………………… (9)

Where i2 is total risk of individual asset; e i is the systematic component of the total
risk and i2m2, the systematic component.

Thus, portfolio variance (p2) =

…………….. (10)

Where p2 = Variance of portfolio return m2 = Expected variance of index

ei2 = variance of asset return not caused by its relationship to the market index
(unsystematic risk).
Stating the importance of the above
relationships (equation 9 & 10), Sanders,
Pagliari and Webb (1995) opined that by
dividing risk into two components, one of
which can be eliminated by diversification,
investors could concentrate on market risk
only. In other words, to the holders of a
portfolio, the risk of any individual
property, in terms of its volatility of
performance due to internal matters,
becomes unimportant. What is important is
how any particular investment behaves in
relation to the hypothetical market
portfolio. Once this is known, measure in
terms of , the effect of the inclusion of that difficulties with the application of SIM,
investment within the portfolio can be
measured. This process avoids the need to
carry out the vast number of calculations
required under Markowitz’s original theory,
as no longer is covariance between each
and every investment required, but merely
the covariance between particular
investment and the market. Thus, CAPM is
usually considered simpler when compared
to MVA. In addition, the linearity measure
of the risk/return relationship appears to
lend itself to well-known statistical
estimation procedure. It is however entirely
dependent on the basic simplifying
assumption of an efficient or perfect market
and this may well not exist in the real
world.
In the property market, the main
especially in Nigeria, include the lack of a
recognised market index or return data from
which to measure market return. This
makes the market to lack efficiency that the
model demands. Also, if SIM is to be
applied to property, it is a prerequisite that a
standard method of appraisal should be
adopted for a true index return (Dubben and
Sayce, 1991).
Notwithstanding the foregoing,
Elton, et al., (2010) and Dubben and Sayce
(1991) concluded that CAPM or SIM is the
most widely accepted and practised branch
of MPT because it offers a theoretically
simple and thus attractive quantitative
measurement of portfolio risk. Reilly
(1994) also opined that if this model helps
us explain the rate of return on a wide
variety of risky assets, it is very useful,
regardless of whether some of its
assumptions are unrealistic. This, according
to the author, is based on the fact that many
of the assumptions can be relaxed with
minor impact on the model and no change
in the main implications or conclusions.
Second, the author is of the opinion that a
theory should never be judged on the basis
of the assumptions it involves, but rather on
how well it explains and helps us to predict
behaviour in the real world. Dubben and
Sayce (1991) submit that imperfect though
property indices are, as long as the
imperfections are to a large extent
consistent, it should be possible to derive a
correlation between such market returns
and properties of differing types, and once
this is accepted, the basic concept of CAPM
can be said to be relevant.
Conclusions
The foregoing discussions have
centred on options available to investors in
property portfolio diversification decisions.
The methods discuss include naïve
strategies such as property type,
geographic/economic diversification,
managers diversification, timing/investment
cycle diversification, investment structure
or vehicle diversification, lease
diversification. The discussion on
quantitative techniques was restricted to
MPT based diversification techniques of
Markowitz Mean Variance Analysis and
Sharpe Index Model.
It is noted in the paper that the
choice of any strategy will depend on a
number of factors that include basically the
attitude or expectations of investors with
regards to risks and returns from a
portfolio. Other factors that exert influence
are the socio-economic environment within
which investment activities are to be carried
out. Investors must also consider the ease of
managing the entire portfolio, the presence
of any legislation and laws that can affect
portfolio’s returns negatively in addition to
comparing the costs of administering
portfolios with the benefits derivable from
diversification. In addition, investors’ and
practitioners’ level of education with
quantitative techniques as well as investors’
loath reaction, when investing with decision
methods that are perceived complex, will
also determine choice of diversification
strategies. Further, the use of diversification
strategies (qualitative or quantitative
analysis) demands that market players are
able to access good time series data with
which they can carry out their analysis.
As a result of the foregoing, there is
need for investors and practitioners in
Nigeria to develop their knowledge of the
quantitative techniques via workshops,
seminars and continuous professional
development programme (CPD). Also, if
Nigeria must adopt MPT based portfolio
diversification, the current efforts at
publishing a centralised property database
on individual properties/portfolios should
be given speedy consideration without
further delay. A move towards this will
ensure maturity/efficiency in the market
which is a major pre-requisite for usage of
MPT diversification.
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