Diversify your Real Estate Portfolio: Why it Matters and How to Really Do It
February 22, 2023
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Real estate investing can be an excellent way to build wealth and generate passive income. However, like any investment, it comes with risks. One way to mitigate those risks is through diversification. In this article, we'll explain diversification, why it matters when investing in real estate, and how you can do it right.
What is diversification?
Diversification is the practice of spreading your investments across different assets, strategies, or asset classes to reduce your risk exposure from being too concentrated in a single asset, lower short-term volatility risk, and potential improvement in long-term value. The idea is that if one investment performs poorly, others in your portfolio can help balance the losses with their gains. The key to proper diversification is to choose investments that are not highly correlated with each other so that they are less likely to move in the same direction at the same time.
When we think about diversification and real estate investments, we can generally think about it in terms of asset, structure, and strategy. Let’s translate this to real examples in real estate investing. In that case, diversification in assets could mean investing in different types of properties, such as residential, commercial, or industrial, or in other locations. It can also mean investing through different structures or vehicles, such as real estate investment trusts (REITs), private non-traded funds, partnerships, or direct ownership. You can think of strategies such as bridge lending, mezzanine debt for multi-family housing, fix & flip for single-family homes with specific parameters, and commercial land leases, just to name a few. There are many ways to diversify, so let’s get into why this is meaningful.
Why diversification really matters in real estate investing
Let’s start by acknowledging that we are human beings and tend to have biases and patterns. This can lead to looking for success in familiar places and making investments that feel similar. Ever heard the recommendation to only invest in what you understand? There’s wisdom in that, but too much of that could lead to portfolio concentration.
Every real estate investment comes with unique risks and challenges. For example, it can be illiquid, meaning it may take time to sell a property to access your cash, and each investment should be thought of as having a unique and different timeline. Generally, real estate is a complex transaction, so it can be expensive, with high transaction costs and ongoing maintenance and management expenses. Finally, it is highly dependent on local market conditions, such as trends, supply and demand, interest rates, and economic health.
Diversification can mitigate these risks in several ways. First, by investing in different types of properties or in different locations, you can reduce your exposure to local market conditions. If one market is performing poorly, others may be doing well, helping to balance out your returns. Second, by investing through different vehicles, you can spread your risks across a broader set of assets and structures, reducing your reliance on any one property or investment. This concept may be a bit tougher to understand, so let’s expand here. Suppose you invest in a single rental property in a high-cost, high-demand urban area. While this property may generate high rental income, it is also subject to a range of risks, such as changes in tenant demand, property taxes, and illiquidity. If you diversify in a publicly-traded REIT that owns a national portfolio of properties across the country, you can help balance out those risks and potentially generate more stable returns over the long term and also find some sources of liquidity.
Diversification matters because, in life, you don’t know when emergencies will strike, so you will want different options to access your capital. Structuring your portfolio to make sense for your life can make a huge difference in the long run.
How you can diversify your real estate portfolio like the pros
Diversification is a simple concept and, at the same time, a complex web of gotchas to navigate. There are so many ways to diversify in real estate. This article isn’t here to serve you as a comprehensive wiki of all the different ways you can invest but to help provide some guiding principles to help you think through diversification. As we mentioned above, you generally can think about diversification in real estate investing across the dimensions of asset, structure, and strategy. Let’s explore those, along with a few other concepts you can use to guide you when trying to diversify your real estate portfolio:
Diversify through different types of properties.
You can think of this in the asset category of diversification, which can include both debt and equity. Real estate investing should always be in or backed by real properties or land.
Residential properties, commercial properties, industrial, raw land, and special use each have their own unique risks and rewards. By investing in a mix of these property types, you can balance out your portfolio and potentially generate more stable returns. For example, if residential properties are experiencing a downturn, your commercial or industrial properties may still be generating income.
Diversify in different geographies.
Expanding on diversifying in assets and property types, and investing in different locations can also help to divide out the risk. Each location has its own risks and rewards. Investing in properties in different regions or cities can help you reduce your exposure to concentrated market conditions. For example, suppose one market experiences a downturn due to a large employer going bankrupt. In that case, your other properties in other markets may hold well or even be on the receiving end of a large influx of new people with a booming rental market.
Diversify in different vehicles.
Investment vehicles, or structures, will have different pros and cons; some may be more advantageous to your goals. The concept here is to think about how you want to acquire the investment and what that means. Take this example: if you want more tax benefits to offset your income, you may consider vehicles that maximize tax benefits that are structured with a pass-through entity. If you’re looking for something more liquid, you should consider publicly-traded REITs and private real estate vehicles that offer liquidity mechanisms. By creating a mix of these strategies, you can think through crafting a portfolio that gives you optionality while taking advantage of longer-term horizons. For example, in the inflationary environment of 2022, coupled with higher interest rates, many publicly traded REITs lowered their dividend rate. However, many privately held income-generating investments were able to positively adjust alongside inflation in their markets by increasing their rents.
Diversify in different strategies.
Strategy can be a vast concept, and choosing strategies is like choosing a movie to watch on Netflix; there are a lot of options. They will all bring their unique turns as the investment progresses over time. Real estate investment strategies range from low-risk and low-return investments, such as first-position lending, to high-risk and high-return investments, such as development projects. By investing in a mix of risk profiles, you can balance out your returns and potentially generate more stable returns over the long term.
A more tangible example would be for investors that have built out a portfolio of short-term rental AirBnB investments to consider diversifying into some real estate debt strategies or even commercial real estate. The reasoning here is that short-term rentals could be susceptible to seasonality, travel trends, and local politics. If a concentrated portfolio of short-term rentals takes a hit, you’ll want to still be able to generate income through other investments.
Diversify along different stages of a real estate cycle.
The concept is an extension of choosing different types of strategies, but really one that’s aligned with those who want to continually invest in real estate or practice dollar cost averaging into this asset class. Like many other asset classes, real estate markets go through cycles of boom and bust. Investing in different stages of the cycle does require you to shift your perspective in terms of addressing head-on what you believe is coming up. For example, if you invest in properties during a downturn, you might find more distress and discounts, giving you the chance of selling them at a higher price later in the cycle when the market has recovered. If you’re investing during a boom, you may want to think through strategies that are enduring or perhaps even development projects if you’re early enough in the cycle. You can think of this as buying into different vintages, and since real estate is a market where information is generally asymmetric, there are always opportunities to take advantage of the current time.
The bottom line
There is no right way to diversify because everyone has different wants and needs, but putting all your eggs into a basket could lead to a potentially catastrophic event.
Diversification is an important strategy for managing risk in real estate investing by considering what you’re looking to really get out of your portfolio and finding balance to maximize your chances of achieving that. Investing in different types of properties, locations, strategies, and structures can help balance out your portfolio and potentially generate more long-term value. Whether you are a novice or an experienced investor, diversification can effectively manage short-term and long-term risk to achieve your financial goals better.
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