Diversifying your real estate portfolio is critical if you want to protect yourself and increase its performance. I’m an investor myself, and I own six residential units. I’m currently also invested in a couple of larger apartment deals. I personally believe that real estate is the most direct path to long term wealth and financial freedom.
Building a diversified portfolio in real estate investments is one of the best ways to minimize risks and drive long term returns. Today I am going to talk to you about three ways to drive better diversification in your real estate investment portfolio. We will discuss diversity in:
- Asset Class
- Risk Profile of the Asset
Diversifying the Geography of Your Real Estate Investments
Geography is one of the best ways to diversify your investment portfolio. It’s not that complicated, and if you’re working with a smart team of local experts, you’re going to have a positive experience in just about any geographical market you choose.
A lot of investors focus all of their acquisitions on a single market. Usually, this is because they know where they’re comfortable. It’s easy to invest in a local market that’s close to where you live, for example. Being in the same city or region as your investments makes everything feel accessible. You know the assets and you know the neighborhoods in the market, and there’s not a lot of guesswork involved. That can feel very safe, especially if you’re a new investor who wants to stay close to home.
However, keeping all of our real estate investments in one market is not as safe as it may feel. In fact, this puts you in a lot of risk if the economics turn in that particular market. If a major employer leaves the region or the population starts to move out or the local economy shifts, you might be left with assets that are no longer worth what they once earned. These are factors you cannot control.
Your portfolio is exposed to the dealings of that market. It’s important to diversify into new markets and locations. That way, your entire real estate portfolio won’t be dependent on a single economy or a single tenant pool. You will be better prepared to endure any potential single economic downturns because you’ll have investments elsewhere. There are a lot of great places to invest right now, and I would encourage you to consider looking at rental properties in other regions.
Diversifying Your Real Estate Asset Classes
Another way to increase the diversification in your portfolio is to look at multiple asset classes. Think of investing in single-family residential properties, multi-family residential properties, as well as commercial real estate. This is going to maximize your returns because each of those different asset classes sees stronger returns in different parts of the market cycle. Being over exposed to any one at a specific time is going to increase your risk as the market turns. And this keeps you from taking full advantage of returns as other segments of the market are seeing stronger returns.
Similar to geographical diversity, this strategy can seem risky. If you’ve only ever invested in residential real estate, making a commercial purchase can seem a bit uncertain. If you never thought beyond the single-family home market, buying a small apartment building might seem completely outside the realm of possibility. We like to stick with what we know, but as investors, we have to be willing to try different things.
Keeping all of your real estate investments in one particular asset class is not going to protect you from risk. In fact, it’s riskier for your portfolio. Be willing to buy different types of properties, and if you’re feeling like you’re outside of your comfort zone, don’t be afraid to reach out to someone who has experience with different types of properties.
Diversifying Your Real Estate Risk Profile
The third way to really drive diversification in your real estate portfolio is to diversify across risk profile. Risk profile is a phrase that people use when they talk about their investments and assets. What it describes is what you’re looking for in your investment profile. How much stability is there in the assets you own? How much of the potential cash flow is your investment property generating at the time you acquired that asset? The answers to those questions will describe your risk profile and give you some clues as to how you might find some diversity.
There are three levels of risk profiles when we are talking about and considering real estate investments.
First, there are the stable, core, turn-key assets. This is going to be the best bet for investors who may be new to real estate or unwilling to take on a lot of risk. The stable assets are the properties you buy when you’re looking for simplicity. They are often occupied with good tenants and they have compliant leases where everything is covered. The tenants are probably paying market rents or close to market rents. And, you’re going to be able to expect a fairly seamless rental process with cash flow coming in almost immediately. These properties have less risk, and they are likely going to see lower returns.
The second risk profile is a little different. These are usually what we call value-add properties. These are homes or buildings that may require some updating. You’ll get a great price for them, and you may have to invest a little time and money in order to get your returns to the market level. As you can see, there is more risk to this strategy. But, once you get those properties to where you want them, they are sure to drive strong returns. These properties usually give you a better return than the properties in that core risk class. It’s the cost of your work paying off in the longer term. The risk here comes in actually executing your strategy of how to get that property up to market rent.
The last risk profile is distressed assets. These are properties that will require a lot of work before you can even think about renting them out and earning. These properties will almost always require a business plan because there is so much effort needed to get these properties up to market rent. One of the benefits to this risk class is that you’ll be able to acquire them at deep discounts. So, you’ll spend a lot less when you’re purchasing. Then, you can execute your business plan for getting them ready for the market. Once you have them out there and listed and tenants are paying rent, you’ll see really strong returns.
If you typically stick to one risk class, consider buying a property that fits a different profile. Challenge yourself, get some expert advice, and see what it does for your portfolio.
Now that we have talked about a few ways you can diversify your real estate business portfolio, I really do want to reiterate the importance of diversification as it allows you to maximize returns over the long run and really minimize the risk of over-exposing your real estate portfolio to a specific geography, segment or risk portfolio.
Drawbacks to Real Estate Diversification
I’ve talked a lot about the benefits of diversification but there are a few drawbacks that are going to make diversifying your portfolio a little bit difficult.
One drawback may be going out of your comfort zone. This can be a challenge, especially if you’re not sure what to expect or how to prepare. You have probably been investing in the asset class that you know, in the geographical region that makes you comfortable, and within a level of risk that allows you to earn what you want to earn. Maintaining a healthy bottom line while learning about new investment strategies can be stressful and time consuming.
One way to manage the learning curve is by working with an outstanding local property management company. A good relationship with the right property managers will immediately connect you with a network of vendors, brokers, mortgage professionals, and other experts. You can use those tools and resources to have a more successful and comfortable investment experience, even while you’re diversifying.
Finding new ways to invest in real estate is exciting, whether you’re new to the investment world or an experienced investor who is growing a portfolio. Remember the value in diversifying your real estate assets, and make sure you do all the research and due diligence you can before you enter a new market, buy a new type of property, or adjust your risk profile.
We have lots of experience in markets across the country. At Mynd, we work with all sorts of asset classes and risk profiles. If you’d like some help planning your next steps, contact us at Mynd Property Management.