As you only have a single post that was some time ago this will probably be academic, but hey...
First off, 'most' 16" rear tyres are fairly tall (like 15" tyres, aimed at flabby cruisers) and you actually end up having it 'bigger' than a more modern 17" would be.
But, let's say you find a nice low profile 16" tyre and manage to drop the back end by an inch or two - here is what will happen:
The handling will not be improved by 'lowering the centre of gravity' - this is a bike, not a car. It'll handle like shit (or like a harley, but those words are interchangable anyway). You might think you can drop the front end to compensate (smaller front wheel/dropping the yokes down over the forks) but it won't compensate at all - a smaller front wheel will make it twitchy and the change in trail will make it wallowy. Yes, it'll be twitchy and wallowy at the same time.
So, let's say that is what you want - a bike that is only rideable up to about 35mph.
Good, because the gearing (exacerbated by the smaller wheel) will mean you are hitting the diesel engine's rev limiter at about 38mph in top. Unless you happen to have a diesel engine that will be able to pull more than 5krpm and be comfortable while doing it?
Now, what I said up there about the handling - that is not a "BMW knows best" rant. I got a rear shock off ebay that turned up and was about 1.25" shorter than stock. It did not go well.... No amount of fiddling would get it to ride right - until I made up a set of brackets to lift the back end again. My bike now sits aroundabout 1.5" higher than stock front and rear and imo is much better for it (on and off the roads here).
I am more than happy to expand on anything I said if anyone is interested.
