According to Modern Portfolio Theory, you should ideally have a 10 to 20 percent allocation in hard assets like commercial real estate; however, this principle also applies to the actual real estate allocation. In other words, there are many ways to diversify the types of real estate assets that you include in your portfolio, and you should definitely do so. In years past, accomplishing this wasn’t easy, but thanks to real estate crowdfunding, it is now easier than ever.
Types of Risk Components
To build a diversified real estate portfolio, you first need a fundamental understanding of the most prevalent real estate strategy categories. You must also understand how to diversify within them, when applicable, to develop a truly diversified and effective real estate investment strategy.
Familiarize yourself with these eight real estate risk component categories to more easily diversify your portfolio:
- Asset Class – Markets fluctuate constantly. These fluctuations sometimes affect all asset classes equally. Other times, however, they hit certain asset classes harder than others. With this in mind, it pays to invest in various asset class types, such as industrial, retail, hospitality, senior housing, multifamily, office, and storage. This approach provides an effective way to mitigate against the cyclical risks that are inherent in any investment activity.
- Debt versus Equity – With real estate deals, it is possible to invest at various points in the capital stack. Some investors stick strictly with debt deals, and others stick strictly with equity deals. These types of deals differ in many crucial ways, and they come with different risks. Therefore, it is advantageous to invest along all levels of the capital stack to spread out the risk more evenly.
- Business Model – Each real estate deal has its own unique business strategy or business plan. For example, some are focused on new development while others focus on value-added situations that may generate minimal cash flow but that produce great returns at the back end. Although you may become comfortable investing in certain strategies or plans, it is better to blend many different types into your portfolio.
- Geography – Investors often seriously underestimate the impact that geography has on their commercial real estate investments. It is important to invest in many geographic locations for optimal diversification. This doesn’t just mean mixing things up based on country, region, state, city, or neighborhood. It also means mixing them up based on the size of the market. For example, a healthy real estate investment portfolio will include assets in primary markets like NYC, in secondary markets like Austin, and in much smaller tertiary markets.
- Risk Profile – Like many investors, you may feel the most comfortable with investing only in stable, low-risk core investments. On the other hand, you may be drawn to opportunistic investments that are more likely to generate high returns but that are more risky. Once again, you shouldn’t focus too intently on any one type of risk profile. Rather, your portfolio should include a mix of core strategies as well as core-plus, value-added, and opportunistic strategies.
- Sponsorship – A huge risk to achieving a diversified real estate investment portfolio is sponsorship concentration, in which you only work with one or two sponsors or types of sponsors. The problem here is that if you rely only on one sponsor and they experience problems, your investments could be put in jeopardy. One strategy is to begin with a pool of sponsors and to re-invest later with a smaller number after assessing them. You should also work with experienced and less experienced sponsors alike, as both bring different benefits to the table. Experienced sponsors provide more protection, but less experienced sponsors are often able to provide better terms.
- Holding Period – Your real estate investment portfolio should also include investments with a mix of holding periods. Short-term holding periods offer good certainty but more intensified time risk. Mid-term holding periods have less time intensity risk but are at risk of hitting at the end of a cycle. Long-term holding periods reduce both of these risks but typically generate lower annualized returns. By mixing between these types, you can reduce the risk of having all exits hit at one time, which could be the “wrong” time.
- Income versus Equity Multiple – Some investors find themselves sticking strictly to equity multiple driven opportunities. Others feel more comfortable with income-producing opportunities. Regardless of where you fall on the spectrum, you should strive to include a mix of these types in your real estate investment portfolio. By doing so, you will have opportunities that generate income while they are being held as well as opportunities that produce little or no yield until they are sold. This will help to increase returns and mitigate risk considerably.
Develop Your Own Strategy
As your investment portfolio grows, it is crucial to adopt a methodical approach to ensure optimal diversification. Unfortunately, there is no such thing as a universally effective investment strategy. What works for one investor may not work for the next. Some focus on a single asset type, like multifamily properties, and diversify by investing in properties in different geographic areas or markets. Some focus on certain business models and diversify by working with different sponsors or holding periods. A good rule of thumb is to not worry about diversification initially but to identify opportunities that excite you first. From there, you can engage in crowdfunding to figure out ways to diversify across the categories that are highlighted above.
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