How many leases are enough to diversify a portfolio of multi-let industrial properties?

Abstract

In modern finance, portfolio diversification is analysed by considering the interaction of the individual portfolio assets: the variances and correlations of the individual asset returns are of central importance. Within parts of the industrial property sector however, diversification is often referred to with a different emphasis. For multi-let properties, investors and lenders are often particularly concerned with the variability of the overall portfolio income and the possibility and extent of shortfalls in income through voids and tenant defaults. In this context, the variability of asset performance (total return) is inadequate in isolation for the analysis of investment risk. With multi-let properties, one of the primary goals of diversification is to reduce the risk of income shortfall. But how many leases is enough to give an acceptable level of risk of income shortfall? This paper attempts to answer that question through the use of simulation techniques. Potential income shortfall is a crucial consideration in lending decisions as the interest cover ratio is a key loan covenant. This makes the question of how many leases is enough to diversify a portfolio of multi-let industrial properties an important one for borrowers and lenders.