In real estate, diversification is a strategy investors can use to support long-term gains by reducing risk. Applying this strategy requires consideration of property types and their potential to project how much risk you accept when investing in them. Explore the concept of diversification and how you can use it with your real estate investments.
What Does It Mean to Diversify Your Real Estate Portfolio?
Diversification is the process of investing in various types of assets so a portfolio is not concentrated in a single source for income or appreciation. This term can refer to many types of investments like stocks and bonds as well as relate specifically to real estate portfolios.
There are three key elements to diversification:
- Investing across asset classes: An asset class is an investment category. Real estate forms an asset class along with other tangible assets, but there are other classes to consider. Stocks and bonds are two well-known asset classes. While you may want to diversify your real estate portfolio, you can diversify on a larger scale by investing in numerous asset classes.
- Adding variety within each class: Adding variety within each asset class depends on the class you’re referring to. Generally, you can think of this level of diversification in sectors, size, location, and other relevant details. When referring to real estate, this variety also includes property types, like residential, commercial, and industrial properties.
- Adding exposure to different management structures: You can invest in real estate in several different ways, such as Delaware Statutory Trusts (DSTs), Real Estate Investment Trusts (REITs), property flipping, and more.
Using the above elements in your real estate investment strategy can help you diversify your assets and reap potential benefits.
What Can Happen if You Don’t Diversify Your Portfolio?
Diversification is not a requirement for real estate investing, but following different methods can have a considerable effect on your risk levels and the stability of your real estate portfolio.
The Disadvantages of Specialization
Choosing not to diversify your portfolio — sometimes called specialization — is also a form of investment strategy. This method involves focusing on a particular asset type and employing the same strategy repeatedly. In real estate, this may involve investing only in residential properties in high-value neighborhoods. Another example could include only buying commercial retail spaces in New York City.
Investors might choose this approach because they feel a historically effective strategy doesn’t need adjustments. A specialized investment strategy directs all funding to a single source. If this asset class faces a significant downturn, the investor faces a major loss without other investment gains to help replace the lost income or principal.
For example, an investor strategizes to purchase only residential properties in Minnesota, but an unexpected spike in mortgage interest rates modifies the state of the market. If an investor is focused on flipping, high interest rates will decrease the demand for residential property and the value of every home on the market.
With potential homebuyers wanting to avoid the high interest rates, buyers are more likely to continue renting rather than purchase residential properties. The investor may have to drop prices significantly to sell the properties in their portfolio. In doing so, the investor loses money compared to their initial investment. Depending on the number of properties the investor had, these losses can be difficult to recover from.
Specialization can work, and it may work for an extended period. However, applying this strategy may come with potentially higher losses than a diversified portfolio.
The Unpredictability of the Real Estate Market
Many high net-worth investors agree that real estate is a trustworthy investment, but it is not free from risks. Without diversification, your real estate investments may lead to losses that take years to earn back. The unpredictability of the market poses the most significant challenges to investors, especially those who do not diversify.
Those who opt for a more specialized portfolio may argue that real estate professionals can predict market behaviors and guide investment decisions. While these predictions can carry weight, the real estate market still offers unpredictable behaviors that may disrupt your investment goals. Counting on these predictions in addition to specialized investments may not offer the level of risk protection you want from your investment portfolio.
The Benefits of Real Estate Portfolio Diversification
Specialization in real estate may be ineffective for optimizing your investments. Diversification is an approach that can deliver notable benefits.
Minimize the Impact of Market Fluctuations
One of the most notable benefits of real estate diversification is reducing potential risks due to market volatility. In a specialized approach, you run the risk of losing your entire investment amidst undesirable market behavior. Diversification enables you to take precautions with your investments, so a loss in one area won’t lead to major losses overall.
For example, an investor’s stake in a series of industrial properties in Minnesota may involve losses during a weather-related event, plant closure, or loss of jobs in the area. However, if this investor also has industrial properties in another part of the country, gains from these properties can make up for the losses in Minnesota.
Diversification can require a level of strategy. Investors have to consider which asset classes and characteristics within these classes are relatively stable and which ones are subject to change dramatically. Ultimately, a mixture of property types can make it easier to recover from losses in a particular real estate sector.
Combine Levels of Risk
Risk levels are an essential aspect of investment strategy. The amount of risk you accept will depend on your goals, which often include factors like the time you plan to keep money invested and how much money you can stand to lose.
Every investor will accept varying levels of risk, but a diversified portfolio can offer many risk levels to a single investor. Just as you can personalize the types of assets in your portfolio, you can determine different portions for high-risk, medium-risk, and low-risk investments.
These combined risk levels offer the same benefits as investing in different asset classes or properties within an asset class. Perhaps you invest a large portion of your money into a high-risk property. Even if this property doesn’t perform well enough to make you money, a series of lower-risk properties will help mitigate overall risk in the portfolio.
Gain From Multiple Sources
The specialization strategy may seem like a smart idea if you know a particular type of property performs well. Diversification, in contrast, can present opportunities for gains you may not have explored. If you’ve had a positive investment history with only single-family homes, you may not know how you can benefit from a multi-tenant apartment building.
With the goal of making more money than you invest, benefitting from multiple sources can offer gains you may never have seen before. Even different assets within the same class can perform differently based on market conditions. Exploring all of the opportunities in real estate investment may help you see high returns.
How to Start Diversifying Your Real Estate Portfolio
The diversification process starts with your personal investment goals. Every investor is willing to take on a different level of risk and invest varying amounts of money. These goals will change over the course of your life, so it’s vital to regularly reassess and modify your investments as needed.
When diversifying your real estate portfolio, there are several areas to consider. Within these different categories, you can identify various property types, assess the associated risk levels and develop a portfolio that reflects your goals.
The property’s purpose will play a significant role in the property’s demand and its risk level. Purposes include:
These asset types will interact with different categories to create the level of risk. For example, a retail space in a location with high tourism year-round is more likely to thrive than a retail property in a small remote town. Factors like location and tenants will also affect how high you can price your rent and how much consistency you can expect from your tenants.
Real estate performance varies across geographical locations, so investing in properties in multiple places can deliver various results. One city might have a competitive real estate market with more renters than available properties, driving up rents. A nearby town may be experiencing a completely opposite market behavior where few people choose to rent, or there are more vacancies than tenants.
Location types include:
- Domestic or foreign
- Regions, such as the West Coast or Midwest
- Urban, suburban, and rural
- Low-income and high-income communities
There will always be unpredictable market behaviors based on geographical location, but there are a few factors to consider when searching for high-growth markets. Population growth in an area will point to a demand for property. An increase in job opportunities can also correlate with new demand for property. Job diversity in an area may lead to many different types of potential successful properties.
Location and property purpose will point to the type of tenants your properties will support. Tenants can reveal several factors, including:
- How high your rent prices can be
- The behaviors you can expect
- The expectations for upkeep
- Consistency of leases
For example, a property geared towards college students may mean lower rent prices and lower expectations for upkeep. If the property is not close to the campus, you may not be able to earn as much on rent. However, you may not need to invest much into the property to improve it. Students can also potentially have higher turnover rates as they move around during college. You may have the same tenants for a few years at the most, or you may face new tenants every year.
Student tenants will vary drastically from credit-rated businesses. A well-established business will likely be willing to pay more in rent, but they may have higher expectations for upkeep. You may also be able to count on this business as a tenant for several years.
Other possible tenants include:
- Small businesses
- Healthcare workers
- Government agencies
A property’s ownership structure can define how much risk you accept with an investment. If you decide on direct ownership, you accept the full risk. Other options, like REITs or DSTs, involve fractional ownership that gives you flexibility in the level of risk you accept.
DSTs can be an option for you if you don’t want to qualify for debt to gain beneficial interest in a property. When debt is involved, the trust takes on the debt, and you are assigned a portion of it based on a loan-to-debt ratio.
The management structure is also an important consideration in your property diversification. You may choose to manage a property by yourself, but this will come with a much larger time commitment. Working with a third-party management company or a fund sponsor can reduce responsibilities across your portfolio, but they will come with an extra expense.
If you opt to work with a third-party management company, consider how these costs may outweigh the time commitment and how they will affect your gains on the property.
Using numerous, diverse strategies across properties can also influence the risk and potential gain. One of your options is the buy-and-hold strategy, where you wait for an upturn in the market to sell and gain. Other properties may lend themselves to the rehab and renting process to generate income over time. Using a combination of strategies can prepare you for market downturns and minimize your risk.
Learn How You Can Diversify Your Real Estate Portfolio With a 1031 Exchange
Diversification can offer benefits to real estate investors. Using 1031 exchanges can help you diversify your portfolio by allowing you to put more of your sale proceeds into a replacement property. This process involves purchasing one or more like-kind properties of equal or greater value to a relinquished property for a tax deferral. You can diversify your portfolio while completing a 1031 exchange without capital gains tax and explore opportunities from various property types and management structures.
At 1031 Crowdfunding, we streamline the 1031 exchange process with an extensive inventory of available properties. When you become a member, you can access these properties and complete a 1031 exchange within a week. Register today to simplify the 1031 exchange process.
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