Savvy investors know that it’s important to diversify their investment portfolios. Diversification reduces risk, because money is spread across a variety of different types of investments, so if one sector does poorly, there’s a chance that the others will make up for any losses. Many investors rebalance their stock portfolios regularly to ensure that they have invested across a diverse range of industries and other categories.
As with stocks, it’s also important to diversify one’s real estate portfolio. If all of an investor’s money is in one kind of property or investment vehicle, then there’s a risk of seeing a lower return — or even losing some of the original investment — if the property or market invested in experiences a significant decline that causes rents or real estate prices to drop.
Here are a few ways one can diversify a real estate portfolio to avoid ending up with all their eggs in one basket.
Diversifying by Investment Method
One way to diversify a real estate portfolio is to use more than one method of investing. Some people like to actively invest in real estate by buying a rental property outright and managing it themselves, but active investing involves a lot of hands-on work, even if you hire a property manager. And unless you can afford to buy a lot of different types of properties, this method makes it difficult to diversify your real estate holdings. For these reasons, many investors prefer to passively invest in real estate.
Real estate crowdfunding is a relatively new method to passively invest in real estate. Through a crowdfunding platform, investors learn about specific properties they can invest in. These properties are reviewed and selected by the deal managers, so it’s critical to choose a crowdfunding platform with strong, experienced leadership. You want a team of real estate experts with a history of successful projects behind them.
While some real estate crowdfunding platforms are run by entrepreneurs who lack deep experience in real estate, ArborCrowd was the first crowdfunding company launched by a real estate institution. ArborCrowd’s experienced underwriting team analyzes more than 500 deals each year to find the ones with the best potential. With more than 30 years of experience, The Arbor Family of Companies has survived and thrived through various market cycles.
Crowdfunding typically has a lower barrier to entry than many other forms of passive real estate investing. Some crowdfunding platforms, like ArborCrowd, require investors to be accredited, which means that they have to meet the minimum income, knowledge or asset qualifications set by the federal government. But the qualifications and minimum investment are often lower for real estate crowdfunding than for other options like private equity or limited partnerships. This enables a wider range of investors to participate in crowdfunded deals.
Private equity is another option to passively invest in real estate. As with real estate crowdfunding, investors typically buy into a deal for a specific property that the deal sponsors have chosen and vetted. So it’s important to choose your sponsor wisely. Investors who want to participate in a deal must be accredited, and in many cases, only very high-net-worth individuals can qualify.
Real Estate Investment Trusts (REITs) are another way to passively invest in real estate. With a public REIT, investors can buy and sell shares in the trust, which owns a number of properties, or in some cases, mortgages secured by properties. Shares in public REITs are liquid, so you can sell them anytime. However, the value of public REIT shares fluctuates with the greater equities market, which means that you may not get the same diversification benefits as you would with other passive real estate investments.
Diversifying by Investment Strategy
There are four main categories of commercial real estate investments to be aware of — Core, Core-Plus, Value-Add and Opportunistic. A well-balanced commercial real estate portfolio often contains a mixture of these different investment categories that reflect the investor’s risk tolerance.
Core investments have the lowest risk profile, and they have a reputation for generating a reliable, conservative return. They are stabilized, attractive, well-located and marketable assets, such as an office building in the central business district of a major metropolitan area. Core properties are typically in good condition with credit-quality tenants and don’t require any improvements. Core investments, however, do not typically yield a large pop in value upon a sale.
Core-Plus investments are fundamentally sound, but may need some improvements or have leases that are set to expire soon. This makes them riskier than core properties, but they also offer the potential to increase rents and add value as leases expire and the property is renovated.
Value-Add investments offer a balance of risk and reward. Investors can increase the value of their investment by renovating or expanding the property and improving operations. For these properties, it’s important to have a deal manager with a clear, well-thought-out business plan in place to improve the asset and increase its value.
Opportunistic investments can be anything from a ground-up development to an adaptive reuse. Often, these properties generate little or no cash flow and are more highly leveraged, making them riskier than other asset classes. However, they often are accompanied by greater overall returns to the investor.
For more information, see our article about the pros and cons of different commercial real estate asset classes.
Diversifying by Property Type
Another way to diversify a real estate portfolio is to choose a variety of different property types to invest in. There are many different options, but here are a few popular options.
Multifamily, typically comprised of five or more residential apartments, is one of the most resilient property types, especially workforce housing, as people always need a place to live.
The self-storage industry too has a reputation of resilience, even during challenging periods like the 2008 recession and the current coronavirus outbreak. Read more about how self-storage has continued to thrive.
Single-family rentals have become increasingly popular, particularly with millennials who lack the savings or credit to buy a home on their own. With more people working from home and wanting more private outdoor space, the market could continue to grow. Learn more about the demand for single-family rentals.
The light industrial subsector of commercial real estate, which includes properties with less than 120,000 square feet that are used for warehousing or light manufacturing, has experienced some growth in recent years. Much of this growth is driven by e-commerce retailers, who use these properties as “last mile” distribution centers to make quick deliveries to customers. Learn more about why investors should pay attention to light industrial properties.