Refining the Analysis of Regional Diversification for Income-Producing Real Estate
The few studies that have looked at regional diversification of real estate portfolios have segmented the United States into four regions without regard to the underlying economic activity in those four regions. In this study, results are presented which analyze the regional diversification issue by segmenting the country into eight regions based on similar underlying economic fundamentals.
The results differ from previous studies by showing that eight-region diversification provides benefits that cannot be achieved from four-region diversification, hence indicating that location does play an important role in real estate portfolio management.
Research to date on relative performance of real estate portfolios by geographic region has separated the country into four arbitrarily defined regions: the East, Midwest, West, and South. For example, the most often cited research using property-specific data to calculate holding period returns makes these classifications (see Miles and McCue, and Hartzell, Hekman, and Miles, in the Bibliography).
Except for the fact that in many cases these states are contiguous, there is little reason for many of them to be combined. For example, in all of these studies, the South includes Texas, Virginia, Alabama, and Florida, which share few common characteristics. Another example of seemingly unrelated states being included within the same region is the West, which includes such diverse areas as Colorado, Montana, Washington, and southern California.
This study provides a more reasonable regional classification than those that have been utilized previously and is based on our analysis of general economic conditions.
The underlying concept behind this study is similar to that found in The Nine Nations of North America, by Joel Garreau. In his book, Garreau segments the country into nine fairly homogeneous regions based upon his experience as a newspaper reporter. While the intuition behind the segmentation in this proposal is similar to Garreau's, the regions are different due to changes in the regional performance since Garreau's book was published in 1981, and due to our own perspectives on longer term regional economic performance.
The regions we have chosen are consistent with long-term trends in real estate. We have also attempted to maintain a regional classification system that can be achieved given the perspective of the traditional institutional investor.
Relation to previous studies
Of the many studies that have analyzed the performance of real estate portfolios, only two have had sufficient property-specific data with which to analyze subportfolios of real estate categorized by various property characteristics.
The first, by Miles and McCue (MM), addresses the benefits to be deprived from within-real estate diversification by region (East, West, South, Midwest) and by property type. Their findings generally support the notion that, because correlations among real estate returns earned on portfolios of properties differentiated by property type were less than similar correlations among portfolios with regional differentiations, the former type of diversification provides more efficiency.
Their data sample consists of major portion of a large commingled real estate fund's holdings over the period from 4Q '73 to 3Q '81, in which inflation was generally tending upward and real estate performance, except for 1974-75, was fairly strong.
The second paper, by Hartzell, Hekman and Miles (HHM), expands the MM database to include 1982 and 1983 and adds other potentially important classifiers such as property size, location in fast-growth versus slow-growth SMSAs, and lease maturity, as well as the regional and property-type classifications studied by MM. Their overall findings were that:
* "All of the subsamples in each of the five categories offer attractive diversification opportunities for the holders of stock and bond portfolios as well as attractive inflation protection," and
* "With the correlation of returns between the real estate categories substantially less than one, there appears to be attractive 'within-real estate' diversification potential as well. …