Our analysis demonstrates that geographic diversification offers tangible benefits for property investors, but there are limits to how far these landlords need to go.
The data suggests that investors only need to spread their portfolio across a few different areas to capture most of the benefits of diversification. Beyond this threshold, the advantages in terms of risk reduction and return enhancement tend to plateau.
The Sharpe Ratio measures the risk adjusted return of an investment. So for example, it balances the fact that a high yielding property in the North East might come with volatile house price movements, which could deem it more risky. The higher the Sharpe Ratio, the better the balance between risk and returns.
"The benefit gained by operating in five or six different geographies, as opposed to three to four areas, is minimal."
As the chart below illustrates, the Sharpe Ratio improves for portfolios that are spread over multiple geographies or have a higher number of properties. However, the gains from expansion tend to diminish. This means that investors can achieve a fairly good balance between risk and returns by diversifying into just three or four different areas.
While the risk-return ratio improves upon further expansion, it rises more slowly. So for example, the benefit gained by operating in five or six different geographies, as opposed to three to four areas, is minimal.
This is particularly relevant for investors who may be concerned about the management challenges of a portfolio spread across the country. Rather, the sweet spot appears to be a modest level of diversification that balances the benefits of risk reduction with the practicalities of portfolio management.
Interestingly, the analysis rules out that a home bias for property investors could be an advantage. Perceived wisdom would suggest that a landlord's superior on-the-ground knowledge of a particular area might generate stronger returns. However, the analysis does not support this theory.
"Non-diversified portfolios have underperformed their diversified counterparts."
Importantly, our research indicates that simply increasing the value of individual properties or the total value of a portfolio does not improve the risk-return profile unless these changes incorporate geographic diversity. For example, a £2 million portfolio concentrated in a single location opens it up to greater volatility and potentially lower returns than a similarly sized portfolio spread across multiple areas.
The cost of failing to diversify geographically can be sizable. Our academic research partners at the University of Nottingham found that non-diversified portfolios have underperformed their diversified counterparts by approximately 2.5% annually in recent years.
In cash terms, these losses equate to around £5,160 a year for the typical portfolio (taking in both lost rental income and house price growth). This represents a significant opportunity cost that compounds over time, potentially amounting to hundreds of thousands of pounds in foregone returns for larger portfolios.
