Investors often turn to real estate for diversification, as it has historically shown a low correlation with the broader stock market, making it a popular component in many portfolios. Real estate offers various investment approaches, primarily through direct or passive methods. Additionally, it allows for further customization by breaking down asset classes and risk profiles. Whether choosing a direct or passive route, investors can explore numerous additional options within each.
In this article, I will concentrate on passive investment options. Many passive real estate investors aim to enhance diversification by offsetting their other passive investments, such as equity portfolios or retirement accounts.
In my discussions with thousands of passive investors over the years, I've found that they seek diversification not only across their overall investment portfolio but also within their real estate allocation. However, as I listen to their plans for diversification, I discover that they are primarily focusing on a narrow area, while, from my standpoint, they seem to be concentrating their portfolio on every other aspect. Here are the ways that I look to diversify my real estate investments.
This represents the most common approach I encounter when investors consider passive real estate diversification. For example, they might have $250,000 to invest and plan to allocate it in $50,000 increments across five sponsors. It's common for them to express the intention of narrowing it down to two or three sponsors as they observe results from each of the five.
Engaging with different investment managers certainly introduces a degree of diversification. One sponsor may exhibit exceptional market insights and operational savviness, while others excel in marketing. Over time, these distinctions will manifest in the results and help mitigate the risk associated with any one sponsor's approach.
There are five primary, institutional asset classes in real estate, with a couple of historically “mom-and-pop” classes that have recently come to prominence:
Other asset classes include self-storage and RV parks; however, these have historically not been considered “institutional” asset classes.
Each asset class poses its own risks and rewards. For example, office, retail, and industrial all offer long-term leases — typically lasting five years or more — which can create more certainty in cash-flow projections. However, as observed prominently in the office sector, economic and social shifts can create significant, long-lasting impacts on the demand. In contrast, multifamily properties with short-term leases tend to be in demand regardless of economic conditions. However, dealing with individuals introduces a different dynamic, where service quality and employment fluctuations can significantly affect the property’s ability to generate cash flow.
There are five primary risk profiles in real estate:
You can dive into each a little deeper with my prior blog post here.
As you construct your portfolio with a focus on diversification, it's advisable to seek assets that align with several risk profiles. Relying solely on a concentration in value-add, for example, means that all your investments will be susceptible to similar market forces, including construction and labor costs, financing timelines, and appreciation requirements that may be swiftly affected by economic shifts.
Real estate is all about location, location, location. It is the one characteristic of real estate that cannot be replicated and contributes to the uniqueness of each investment. However, being overly concentrated in one geographic area can impact the diversification of your portfolio.
The sunbelt states have experienced sustained growth, attracting the attention of many sponsors for valid reasons. Population and business growth and business growth in these regions can help fuel demand for all types of real estate. But with this increase in demand comes higher prices, which often leads to lower returns. Additionally, you run the risk of oversupply in those markets, as the same demand that is generating the rush of acquisitions will also fuel development.
Many sponsors and their limited partners were not prepared for the Fed’s rate hikes in 2022 and 2023. Due to the increase in prices, bridge debt became the preferred lending source for sponsors in all asset classes. While this debt certainly has its place within a well-balanced portfolio (just look at any major corporation that utilizes corporate bonds, bank lending, lines of credit, etc.), building a portfolio that is overly dependent on one style of financing creates additional risk.
A diversified portfolio should incorporate a blend of floating and fixed-rate debt, coupled with laddered maturities. This approach combines the advantages of floating and fixed-rate debt while preventing a scenario where all investments made in a single year are likely to be sold simultaneously, which may or may not be optimal for your overall return.
It’s important to note that financing types can be considered “secondary” to a diversified pool of asset classes and risk profiles, as these two factors often dictate the financing placed on the respective deals.
Much like building a bond portfolio, a well-diversified real estate portfolio will include assets with varying hold periods. Similar to my comment on financing risk, hold periods are often driven by the risk profile. For example, you will see most Core investments being underwritten for 10-year holds or more and then matched to financing that complements this anticipated hold. Value-add assets, due to their age, are often three- to five-year holds and matched to financing that is tied to this business plan.
Like with any type of investing, understanding your goals and risk tolerance is always the first step in real estate investing. The marketing messages you hear from sponsors can pose a challenge here, especially in passive investing.
If appreciation and trajectory of capital are your primary goals, you should not count on immediate, consistently strong cash flow from an investment. And if stability and consistent cash flow are your goals, investing in value-add deals alone will likely not meet those needs. If you’re like most people and want a combination of both, you’ll often need to spread your risk across investments.
About the Author:
Evan is the Director of Investor Relations for Axia Partners, a diversified real estate fund operator, focused on recession-resilient assets. With over 16 years of real estate experience, Evan spends his days working with investors to better understand their investment goals and backgrounds. Please feel free to connect with Evan on LinkedIn, where he shares his insights into the syndication space.
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.