[Editor's Note: This republished post about real estate portfolio diversification comes from WCI Network partner, Passive Income, MD.]
Most of us already know that diversification helps reduce the risk of loss. This, in turn, helps create a more stable return for the investor.
As someone whose goal is to create multiple streams of steady, passive income, the stability of those returns is extremely important to me.
This is part of the reason why I diversify like crazy. Sure, there are times when I wonder if I’m just an investment collector, but this diversification allows me to sleep well at night.
Doctors Like Certainty and Steadiness
As doctors, we’re a pretty risk-averse bunch. It makes sense; we followed a very clear and certain career path. Many of us these days would rather choose the job with good benefits and pension rather than trying to strike it out on our own in today’s rapidly changing environment for physicians.
Not only that, but we’re used to acting in the best interest of patients by first using all available evidence and data and then carefully considering the risk-benefit ratio of each move. First, do no harm.
This mindset is why I think that diversification, and the resulting decrease in volatility, is something that suits us well. While huge returns are attractive, it’s more important for most of us to preserve our capital, and avoid huge losses.
Having said that, I’m a little more risk tolerant than some, having tried many different investments and ventures–some failed and some succeeded. So, I’ve gotten somewhat used to the idea that failure is just a stepping stone to success.
But even I don’t want to ride the highs and lows. I’d rather see a steady check hit my bank account every month and feel good knowing that my money was working for me, not me working as a slave to the money.
So when it comes to trying to diversify in real estate, and especially when investing in more passive real estate investments, it’s important to know how to create that diversification. You need to know what the risks are and how to create that portfolio.
Here are some of the major ways to make sure you diversify your real estate portfolio:
People like to talk about the real estate market as a whole, but in reality, real estate is a very local economy. Different parts of the country, different parts of the state–heck, even different parts of a city–behave differently with changes in the economy. Every market has a submarket.
That’s why “concentration risk” is a real thing. Having all your eggs in one basket (concentrated in one city or one area) can lead to issues if there are political changes, economic changes, or even natural disasters.
Some examples of that:
- In this country, and even across the world, we see reports of fires, floods, hurricanes, tornadoes…the list goes on. These things can wipe out entire investments in one fell swoop (that’s why you also get insurance). Think about flooding in Houston or New Orleans.
- Imagine if you’re investing in a single area and they change the laws in that area to enact rent control issues, change property taxes, or change AirBnB laws. Political risk is real and these exact things are currently happening all across the country, affecting real estate investors.
- Finally, look at what happened in Detroit when the automotive industry dried up. People lost jobs, the local economy was in shambles, and the real estate market tumbled. Industry and job diversification is important. The way to be hedged against things like this by investing in different areas. That’s why, even though I love my city and I have some properties here, I’m happy to invest out of state and continue to look for new opportunities to do so.
Asset Class Diversification
In real estate, an “asset class” would be an apartment building, an office, or an industrial building, etc. Even self-storage and mobile home parks have been getting popular lately. It’s good to stick with what you know, but it’s also nice to have some diversification.
Some asset classes tend to do better in certain economies. Imagine high-rise luxury apartments in the middle of the great recession of 2008. As people were losing their jobs and making less money, those luxury apartments had issues with vacancy.
However, retail stores like Walmart and Target did great during that time. The owners of retail strip malls that had those stores as anchors likely performed well.
At the same time, you don’t need to invest in every asset class. Do what you’re comfortable with and what you know.
Personally, I like to invest in many different ones to try to learn about them. As I always say, you learn best by having a little skin in the game; it amplifies and supercharges the learning. Still, do whatever feels right for you.
When investing in more passive real estate opportunities, whether it’s a syndication or a real estate fund, the sponsor is the one running the deal. They’re the ones who must understand everything about the local markets, and ultimately making things work out well for the investors.
That’s what makes these opportunities so passive. You invest your funds and the sponsors use them to run the deal and provide returns for the investors. The reason it’s so passive is that you’re giving them the reins and the control. So, as you might have guessed, trust in that sponsor is paramount.
It’d be nice to stick to one sponsor for life, but things happen – management and company changes, and plus, not every sponsor is perfect.
And of course, you never hope to run into a situation involving fraud, so thorough due diligence is critical before making any investment.
Again, knowledge of the local area is extremely important, and it’s difficult for one sponsor to understand every market out there. But there are deals to be had everywhere.
Real estate is cyclical and market timing has a big impact on your returns. Imagine if you had planned to sell a building in 2008-2009, during the peak of the recession. Now imagine that you had planned to sell in 2018. You have the same amount of skills and knowledge, but in this case, market timing would’ve gotten you.
So just like maturing bonds or CDs, it’s not a bad idea to diversify for different exit points among investments. How do you do that? Well, you could create a crowdfunding ladder.
Another way to do this is to invest in real estate funds where they exit and sell properties in their fund over 3-5 years. I talked about this in the life cycle of a fund. If a RE fund is expected to go for 10 years, a typical example might work like this:
For the first five years the fund purchases properties, while in the last five years, they’re winding down, selling those properties, and giving investors their returns. In this scenario, at least the risk of timing the market is spread out.
How I Do It
So how do I achieve these things? I’m a nut when it comes to diversification so I will invest across many asset classes. I do this by investing in my own properties as well as when I invest in private real estate opportunities, like syndications and real estate funds.
I’m conscious not only about the asset class but what part of the country I’m investing in. I also consider what commercial real estate strategy is at play (Core, Core+, Value-Add, Opportunistic).
The due diligence does become a little bit of a challenge because I have to go through the process each time, but in some ways, I enjoy it. I feel like every time I perform that due diligence, I get better, faster, and more proficient at it.
Another way I do this (almost instantaneously) is by simply investing in real estate funds and I’ve been investing a larger proportion of my investment funds into them. One example is the $50,000 investment I made in MLG Capital, a partner of this site. With one investment, I’m able to diversify across many properties, across many states, across asset classes, and across many operators, and many exits.
But what about sponsor/operator diversification. Well, in this case, I’m able to achieve it because MLG’s Fund acts as both an operator as well as a capital partner with other operators who have local knowledge in specific markets. In other words, they’re kind of like operators and investors at the same time.
I Feel Ready
At this point, I feel I’ve achieved a fair level of diversification. But the only way to tell how effective it is will be in the next large economic downturn.
However, local economies are changing all the time, and despite weather issues, asset classes changing, and other issues, so far the income has remained steady. Again, the diversification helps me sleep at night and continue to live life how I want, and that means everything to me.
If that good night’s sleep means anything to you, then it’s so important for you to diversify your real estate portfolio as well. Make it happen!
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Any other ways that you’re diversifying in real estate? What are some other risks you feel the need to mitigate?
Find and join our Facebook group, Passive Income Docs! Or, comment below. Either way, I welcome your feedback!
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