Why & How To Build A Diversified Real Estate Investment Portfolio?

A diversified portfolio is the only free lunch!

Many, if not most, real estate investor have a niche, their thing, that asset type they know better than anything else. That can be very profitable during market upswings. However, given enough time, EVERY market experiences downswings. Whether it's a self-inflicted event (looking at you 2008), natural disaster, Federal Reserve actions, or some unforeseen event (you do remember 2020, right?) markets will experience corrections.

If all of your real estate holdings are in one asset class and in one geographic location, you may very well experience immense pain when this inevitably occurs.

So how can an investor or small family office supposed to not only survive, but thrive, in a tumultuous environment.

Portfolio Diversification!

Why real estate diversification is vital!

Unless you want to possibly lose everything in a market downturn, portfolio diversification is an absolute must. Every real estate investor will feel pain during these times. How much is almost entirely up to the portfolio they've constructed. Investors with poorly constructed real estate portfolios are more likely to sell out of necessity. Poor cash flow, broken loan covenants, higher vacancy rates, and defaults become reality in this environment. Since prices will likely be depressed at this time, an investor may need to sell not only under performing assets but those they would prefer to preserve. Thus reducing the portfolio's performance even further.

It becomes a vicious cycle. Personally, I've seen some investors still trying to recover almost a decade after the Great Recession.

Diversifying your real estate portfolio is similar to hedging. Various assets will perform independently of one another potentially providing a buffer. You may not experience the rapid, exciting growth in value across your whole portfolio. But you'll be better positioned for when markets go sideways.

Luckily, there are several effective methods to diversify your real estate portfolio.

#1 - Diversify across asset classes

This should be the most obvious method of diversifying your real estate portfolio. In a similar way to how you might have different stocks, bonds, mutual funds, etc...in your retirement portfolio, you can own different types of real estate assets.

Obviously, investing in apartments vs office space vs industrial can lead to a diverse portfolio. Provided that no one asset class represents too large a percentage of the portfolio. But you can also diversify across classes within an asset class. Think Class A multifamily, new(er) downtown stabilized properties, vs Class C multifamily in tertiary markets, older buildings in need of capital expenditures.

One thing to keep in mind is that you should completely understand the asset classes you're buying into. This can become more challenging when multiple classes are involved as, by definition, they will not perform in the same manner. Lastly, make sure you completely understand the risks (population, income, environmental, economic) associated with each asset class.

“Money is made on the purchase, not on the sale.”

#2 - Value-add vs. Stabilized

Do you want to purchase a property with high vacancy, short term leases, in need of significant capital expenditures with potentially inconsistent short term cash flow? Or would you prefer long term tenants, long term leases, minimal repairs needed, and consistent cash flow upfront?

This is not a trick question. There is a large percentage of investors that seek only the first kind of property known as a value-add. The thinking is that these properties may be purchased as distressed assets and turned into highly profitable properties over a specific time horizon based on their research. Lastly, at time of sale the investor may yield a much larger profit due to their business planning, risk tolerance, and ability to make a property profitable.

Stabilized properties are almost the exact opposite of value-add. These properties are in need of minimal repairs, have long term tenants & leases, and provide immediate cash flow. However, as these properties are not distressed you likely won't purchase them below market value. Over the same time period, these assets may see less profit upside at the time of sale.

It's similar to deciding between a blue chip, dividend paying stock vs a high growth potential but currently low revenue stock. Both options have risk. So what's your risk tolerance?

#3 - Diversify across geographical regions

As I stated earlier, most investors have a specific niche. If you really want to only be in one asset class, then diversifying across geography is another way to go. Geography plays an important role in real estate performance. You should carefully weigh population growth, employment opportunities or lack thereof, income demographics, potential impact of weather cycles, insurance costs, real estate tax structure, dominant industries, and more for this strategy. Some areas will be great for potential value appreciation while others better for annual cash flow. There could also be tax benefits present in one region that others do not offer. Also, be aware that investor/landlord rights vary across geographies. There may be rent controls or other idiosyncrasies you're unaware of. I highly advise speaking with your tax and legal advisors when identifying these opportunities.

If a large, regional employer closes this will definitely have a negative effect on real estate in the area. However, it will have little to no impact in a different region. Likewise, a natural disaster and associated insurance costs will have little to no bearing across the whole portfolio. Population migration from one region to another could have both negative and positive effects on the portfolio.

Photo by Expect Best

#4 - Active vs. Passive Assets

Many of the real estate investors my team assist are heavily invested in active management properties. Some asset classes are by definition more labor and time intensive. Most real estate investors reside in the active category.

There are alternatives.

Passive real estate investments are everywhere. From the local fast food drive-thru, the big box store in the retail district, and the large Class A downtown offices we see these types of investments everyday. And they may be perfect for your 1031 Exchange.

NN/NNN Lease: These types of properties provide investors the opportunity to own often times stable, long term tenant properties without day-to-day management responsibilities. The structure of the lease could include the tenant being responsible for real estate taxes, property insurance, maintenance, and all improvements; or some combination. Leases may be in excess of ten years and rent increases may be included on an annual or lease term basis. If you're looking for relatively hands-off investment real estate, a net lease should be considered.

Delaware Statutory Trust (DST): A DST is an investment vehicle in which a large group of investors (beneficiaries) pool their funds, through a sponsor, to purchase large real estate assets that would ordinarily be beyond their ability to purchase as individual investors. DST's allow access to commercial grade investments normally owned by REITs, pension funds, and large institutional investors. Examples of these assets would include large Class A downtown offices, warehousing and distribution centers, and regional shopping centers. Keep in mind, however, the trust not the individual investors actually owns the asset. However, since the IRS sees fractional ownership in DST's as actual property ownership, this may be a great alternative for a 1031 Exchange.

You don't have to leave your real estate investing to the whims of the market. Yes, there will always be downturns and recessions. However, diversifying your real estate holdings you can minimize the damage done.

I've outlined several ways you should consider diversifying your real estate holding. Work with your real estate, legal, and tax advisors to help create a plan to better weather the inevitable storms. Without risk, there would be no investment payoff. Minimize that risk by creating a cash flowing, diverse real estate portfolio.