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Diversifying Your Real Estate Investment Portfolio

Whether you’re new to investing or you’re a career investor, you should understand the importance of diversity within your portfolio. The higher percentage of your portfolio that is invested in one investment or one type of investment, the greater risk you have of experiencing a significant loss of capital. However, when your portfolio is diversified among many types of investments, the likelihood that each type will experience loss at the same time is low; therefore, your risk of capital loss is significantly decreased.

Real estate is often considered one type of investment. Many financial advisors may recommend that you limit your real estate investments to a certain percentage of your portfolio. Similarly, you’d probably be told to limit stocks, bonds, commodities, foreign stocks, long-term investments, short-term investments, fixed income investments, etc. in the same way.

But if you know real estate, you like real estate, you’ve had success with real estate, and you want to invest in more real estate, why limit your real estate allocation to an arbitrary percentage when you can take measures to reduce your risk by diversifying within real estate itself?

By no means would we suggest you dismiss your advisor’s recommendations or disregard other investment vehicles, we simply believe that with careful consideration to diversification, those who are partial to real estate can increase the percentage of the real estate portion of their investment portfolios while maintaining minimal risk.

Because real estate is such a broad category, it is not difficult to invest in diversified real estate. There are many different aspects of real estate to consider that will differentiate one property from another: the property’s purpose, location, size, tenant, owner, manager, and more. For example, here is a list of many different options within each aspect.

Property Purpose

  • Residential
  • Industrial
  • Retail
  • Commercial
  • Office
  • Healthcare

Tenants

  • Individuals
  • Families
  • Small businesses
  • Credit-rated businesses
  • Government agencies
  • Healthcare professionals

Location

  • Domestic
  • Foreign
  • East Coast
  • West Coast
  • Midwest
  • Southern
  • Urban
  • Suburban
  • High income community
  • Low income community

Ownership Structure

  • Direct Ownership
  • Indirect Ownership
  • REIT
  • Delaware Statutory Trust
  • Real Estate Funds
  • Mezzanine Lending

Management Structure

  • Self-management
  • 3rd party management company
  • Fund Sponsor

The list can go on and on. Of course each option listed under any of the given aspects of real estate is not going to be independent of every other option in that category, but with due diligence and strategy, investors can reduce risk by choosing types of real estate that should not all be affected under the same circumstances. Consider the various ways these investment properties could result:

Property 1

  • Single family residence
  • In the heart of Chicago
  • Owned and managed by an individual investor
  • Occupied by a family

Property 2

  • Multi-family apartments
  • In the heart of Chicago
  • Owned and managed by a REIT
  • Occupied by multiple families

Property 3

  • Industrial facility
  • In the heart of Chicago
  • Owned by an individual
  • Managed by a 3rd party
  • Occupied by family business

Even with minimal differentiation, these properties have the potential to have very different results in a time of economic hardship. The single family property may be harder to keep occupied if the property owner does not have a vast network to find prospective tenants; however a single family urban residence may be in high demand due to short supply. The apartment complex is likely to maintain residents regardless of the economy. During down economic times it may attract families who’ve had to downsize, and during high economic times it will attract younger individuals and families who are ready to stand on their own feet. Additionally, with an experienced manager and a large network of resources, the complex should have sufficient support to operate efficiently. The industrial facility, though situated in the same location and occupied by a family business, has a completely different purpose than the other two properties. If the tenant business is producing a necessary commodity or providing a necessary service, it may be resistant to an economic recession, increasing the security of the real estate operations.

Furthermore, consider how the operating results would be different for each of these properties if they were located in a coastal suburban community. As you can see, each aspect of real estate (the purpose, location, tenant, etc.) has a big impact on the operation of a property. A property that has a risk of tornado damaged in Oklahoma would not have the same risk in Oregon. Retail properties and healthcare facilities are unlikely to be negatively affected at the same time. Urban areas and suburban communities are unlikely to dip simultaneously. A property owner and a lending investor are unlikely to face the same challenges.

Real estate investing offers a broad spectrum of models. By choosing different options from the different aspects of real estate, you can stack your deck for a lower-risk, diversified real estate portfolio. There’s no right combination that will give you a guaranteed real estate success, but when you are invested in multiple properties that differ from one another, you have a good chance of maintaining positive cash flow overall. While some of the properties may experience times of lower income production, others will thrive.

Look for more on diversification as we explore the benefits of different types of real estate in our next blog.

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