How and Why You Need to Diversify Your Real Estate Portfolio
June 5, 2022
You've likely heard the term diversify, but do you know how it pertains to your real estate investment portfolio? Are you aware of how and why you need to diversify your real estate portfolio?
Like any investment, diversifying is the key to solid returns. While there's never a guarantee of a positive return, when you diversify your portfolio in the real estate market, you increase your chances of better returns.
What Is Diversification
Diversification is when you spread out the risk of your investment portfolio. You invest in assets in different markets or of different types that can offset the risk of a total loss. When one investment performs poorly, another may perform well, so the risk isn't as high.
It may seem difficult to have a diversified portfolio with real estate investments, but there are many ways to do it. For example, you can invest in residential real estate and commercial real estate. You can also diversify in different geographical markets or put some money in physical real estate and other money in real estate investment trusts.
Why Diversify Your Real Estate Portfolio
Portfolio diversification is important no matter what you're investing in, including real estate investments. When you put all your eggs in one basket, you risk a total loss if things fall apart. When you diversify, you offset the risk by investing in different asset classes or, in the case of real estate, different property types and locations.
When you diversify your capital, you reduce the risk of a total loss when one investment falls apart. For example, let's say you invested in real estate in Miami, and the Miami market experiences a downturn. If you had all your money invested in Miami properties, you'd lose everything. But if you had money invested in Miami, Washington, and Chicago, for example, you might not lose everything if the Chicago and Washington markets downfall.
How to Diversify Your Portfolio in the Real Estate Market
There are many ways to diversify your real estate portfolio. The more ways you diversify, the less risk you take. Of course, as is the case with any investment, there are always risks of loss as no investment is guaranteed.
Type of Asset
One of the easiest ways to diversify with real estate investing is investing in different asset types. For example, you could invest in a rental property, a piece of commercial real estate, and a real estate investment trust.
Putting your money in different types of assets increases your chances of investing in assets that perform differently. For example, if the residential market cycle crashes, it doesn't mean the commercial real estate industry will too, so you might offset a loss when one market crashes but another doesn't.
Passive Vs Active Investments
Many investors assume they must only have active real estate investments when in fact, a good real estate investment portfolio has a combination of passive and active investments.
So what does that mean- active and passive income and investments?
Active investing in real estate looks like buying rental properties, owning them, renting them out, and maintaining them. You are 100% responsible for the property, choosing the tenants, collecting rent, paying taxes, maintaining the property, and eventually selling it. You put in your time with this investment.
Passive investing in real estate investments looks like buying shares of a real estate investment company that does the 'active investing' for you. Real estate investment trusts are one example. You purchase shares of a real estate company that buys commercial properties, rents them out, and manages them. As a shareholder, you earn a portion of the dividends, plus monthly rent and capital appreciation.
A diversified portfolio with active and passive investments gives you the chance to earn from many types of real estate assets, with the potential of each performing differently.
Real estate investors, especially beginning investors, often don't realize they can branch out to various locations. You don't have to invest only in the area you live.
If you invest outside of your area and buy rental properties, you can hire a property management company to manage the property for you.
What's the benefit of making a property investment outside of your area?
You invest in different markets and can take advantage of various market cycles. It's rare that two different geographical markets perform the same way, so if one market performs poorly, another may perform well, bringing in the cash flow you need.
Using different real estate investment strategies in the same portfolio can help you diversify your real estate portfolio.
For example, you might buy a couple of multifamily properties, hold them and rent them out. You may also buy fixer-uppers, fix them up and sell them right away, and invest in a real estate investment trust too. This allows you to take advantage of various investment strategies, none of which may have the same returns.
Adding both short-term and long-term investments to your portfolio is another great way to diversify. As we talked about, with different strategies, you can invest in multiple properties that you hold onto and rent out and those that you buy and sell quickly. Having investments with varying hold times allows you to take advantage of the market at different performance levels.
Investing in different asset classes also allows you to take advantage of the market's performance at different times. Because, like the stock market, you cannot predict how the real estate market will perform, investing in asset classes such as multifamily properties, single-family residential properties, and commercial properties diversifying your risk at different times.
Spreading your capital across many real estate investments can also mean buying properties of varying values. You might not even invest in rental properties either. For example, you might buy an undervalued home that's a 'steal,' fix it and sell it. As a result, your investment cost is low, giving you more potential for a higher return.
At the same time, you might invest in higher-cost commercial properties or single-family homes that you hold and rent out for the cash flow.
Your investment cost across the board varies, which helps diversify your portfolio and your returns.
Diversifying your portfolio based on risk is important too. While all real estate investments have some sort of risk, identifying with real estate investments are higher risk than others can help you spread your capital out among many different investment types.
Benefits of Diversifying Your Real Estate Portfolio
Diversifying your portfolio offers many benefits, so much so that there really aren't too many downsides of a diverse portfolio unless you over diversify and spread yourself too thin.
Here are the reasons you should consider a diverse real estate investment portfolio.
Real estate investing requires taking a risk no matter how low risk you think you go. However, by diversifying your portfolio, you spread out your risk. When you invest your money across different markets, asset classes, and real estate holdings, you reduce the risk of a total loss when one asset doesn't perform well.
Investing in various real estate assets opens up the opportunity to earn more growth. While it's never a guarantee, but when you invest in active and passive income investments, you increase your chances of higher earnings.
No single asset class will perform well all the time, but when you diversify your entire portfolio, you have a better chance of having consistent returns. In other words, when one investment performs poorly, another may make up for it and perform well. This way, you have very few gaps in your cash flow. However, even diversifying your portfolio doesn't guarantee a positive return.
Long Term Stability
Real estate investing can bring with it ups and downs. While the real estate market as a whole usually performs well, as we saw in 2008, the housing market can crash quite fast. When you diversify your capital, you benefit from long-term stability, with different investments making up for one another during times of turmoil.
Diversified Real Estate Portfolio Example
A diversified real estate portfolio can look many different ways, but here's an example of how it might look.
You buy a rental property in your area. You manage the property yourself and collect the monthly rent, keeping the property for many years. In addition, you invest some of your capital in an inexpensive fixer-upper that you hire contractors to renovate so you can sell it for a profit in a few months. You also buy shares in a real estate investment trust that invests in commercial properties and purchase shares of a real estate company on the stock market.
Is There a Down Side to Diversifying Your Real Estate Portfolio?
There can be a downside to diversifying your portfolio if you overdo it. If you spread your money too thin, you won't see the returns you hoped to get, and the costs could add up significantly taking away from your profits.
What Is the Best Asset to Invest In?
There isn't a single asset that is 'the best' asset. The right asset for you is the one that fits your risk tolerance, has a history of the performance you need to reach your financial goals, and that has the costs that fit within your budget.
The Bottom Line
Now that you know how and why you need to diversify your real estate portfolio, it's time to put the theory to the test. First, look at your risk tolerance and long-term goals and decide which asset classes would fit the best in your investment portfolio. Learn more by signing up and visiting our blog.
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