The real estate market has become highly volatile in the recent past, in part because of the ever-shifting consumer trends. This has led even the strongest of investment portfolios to experience a few periods of loss every now and then.
Nonetheless, you can considerably mitigate those losses by diversifying your portfolio allocation.
In doing so, you basically increase your portfolio’s total return potential. However, it is important to remember that not all diversification approaches are created equal, and choosing the right one is critical to determining how successful your investment will be.
Today, a number of investors are diversified within and across different sectors, industries, and asset classes – but, generally all within the stock market, which happens to be a public market.
With the public market contracting at a rapid rate, and control of stocks becoming more consolidated, meaningfully diversifying your investment portfolio in the public market alone is becoming an increasingly difficult feat to achieve.
The increased accessibility and exposure that comes alongside investing in the private market – particularly real estate – offers individual investors fresh options outside of the stock market.
The benefits of real estate, including the potential for regular income, a history of long-term appreciation, and little performance correlation with the stock market, can make it a robust diversifying investment option for your portfolio.
In this piece, we look at how investors can easily diversify their portfolios using real estate and create multiple dependable streams of income in doing so. But before that, let us look at:
What Makes an Investment Portfolio truly Diversified?
Diversification is particularly leveraged by investors to enhance the return potential and stability of their portfolio by mitigating the risk of loss. When risk is reduced using diversification, a portfolio’s volatility also gets reduced by manifolds almost instantaneously.
The lesser the volatility, the greater the probability of an investment portfolio to be truly diversified. Also, in the case of such a portfolio, the earning potential is also likely to be more consistent and predictable.
Thanks to their portfolios, rather than riding the waves of public stock exchanges or segments of them, diversified investors are usually able to follow a steadier and quieter investment route.
So, the important question here is – what does a diversified portfolio truly look like?
A robust diversification strategy is usually the one that tries to maximize a portfolio’s risk-adjusted returns. To be more specific, they recommend choosing investment options that offer the highest return rate at the risk level that’s most acceptable to the investor.
In the case of most investors, their risk endurance for their investment portfolio is likely closely linked to their investment horizon and end goal. Once you realize your risk tolerance level, you can then begin to figure out your portfolio allocation. By investing in assets with no or very low correlation, you can considerably mitigate unwanted risks in your portfolio.
This is especially true because when investments are interrelated, they share at least some, or at times all of the exact same set of risks. Therefore, if one investment experiences a loss, then a correlated investment is also at a greater risk of loss.
On the contrary, if your portfolio holdings are spread across disparate assets, the performance of one or more investments could actually help alleviate losses when another asset underperforms.
The primary reason behind this is uncorrelated assets have a lower probability of losing value in tandem than correlated investments.
How to Diversify into Private Market Real Estate?
There are various ways to diversify into real estate in the private market, each of which requires different levels of expertise, time commitments, and capital. There’s also a plethora of both short term and long term investment strategies available out there for different types of investors.`
Real estate investing can broadly be broken down into two categories: active and passive.
Active Investing
Active real estate investing options for individuals include rental properties and house-flipping.
Return potential for each of the options that fall under this particular category is restricted to rental income and appreciation. Moreover, this investment technique typically requires hands-on management and a considerable amount of personal knowledge of real estate.
One best practice here would be to hire professionals that have proven expertise in managing properties and handling rental operations, such as a property management service provider or company. Property management platforms are proving to be an asset for modern-day landlords. These help you manage your landlord responsibilities so you can focus on expanding your investment portfolio.
Having said that, it is important to remember that active real estate investing often demands large capital commitments upfront and for the duration of the investment.
For instance, if you purchase a rental property, any money that goes toward buying the property, such as mortgage payment or a down payment, will be tied up in the property for the span of the lifetime of the investment. Only upon selling the property can an investor access the principal and any appreciation they might have earned.
As an owner of a rental property, however, an investor can easily earn in the form of rental payments that usually happen on a monthly basis. A rental property is usually a long-term buy-and-hold strategy and can get you fixed income for as long as you hold it.
As for house-flipping, which is the second most sought-after active investing option leveraged by most investors today, it is normally completed in a shorter timeframe than a rental property; but it also usually comes with a lot more associated risk and responsibility.
It requires an investor to buy a property and then adds value to it within a target budget in order to be able to sell it at a profit within a given timeframe. Any blunders, seen or unseen, can considerably reduce, or even eliminate return potential.
Passive Investing
Passive real estate investments in the private market are closely related to what’s found in public market investments when it comes to determining the investor’s participation and risk stratification in the investment.
In simple words, passive real estate investors usually dispense only capital and allow professionals to invest in real estate on their behalf, just as in the case of the stock market.
With this kind of arrangement, investors are responsible for their investments alone, which keeps them at bay with all the additional liabilities that come alongside active investing.
Some of the commonly leveraged passive real estate investing options include:
- Crowdfunding,
- Real Estate Investment Trusts (REITs),
- Tax Liens,
- Remote Ownership, and
- Money Lending.
Passive investment techniques usually offer real estate investors more options to diversify their portfolio, which in turn, offers greater diversification potential than active investments. And unlike active investment techniques, which earn returns fundamentally through rental income alone, passive investments can hold debt investments, which can also earn returns through loan interest payments in the long run.
On top of these benefits, certain passive real estate investment options have far lesser investment minimums. This makes it easier for investors of all sizes to choose from a variety of investing options.
Commercial vs. Residential Real Estate Investing
Comprehending whether you’d want to move ahead with a commercial real estate investment, or a residential one isn’t something that you can go about in haste. It demands both time and effort!
Each strategy furnished before investors its own set of both advantages as well as challenges. The path an investor chooses to take will depend on various factors such as their risk tolerance, the end goal, liquid capital, total time at hand, loan requirement, etc.
Commercial real estate tends to award investors with a much greater scale and scope of a potential investment. For instance, there are a lot more commercial property investment funds than residential ones. On the contrary, residential real estate investing tends to give investors a more active, hands-on approach with respect to their property.
Another important difference between these two types of investment options is loan availability.
Conventional residential loans, also known as residential mortgages, are usually distributed to borrowers by banks. Unlike residential mortgages that typically take place between banks and individual buyers, a commercial mortgage is made to an organization.
Furthermore, commercial loans are usually considered to be high-risk (by lenders) than residential loans. This makes the interest rates for a commercial loan a lot higher and terms shorter, especially because there is a whole secondary market for commercial lenders that is disparate from traditional banking institutions.
In order for an investor to qualify for a commercial loan, they are usually required to have a solid credit score and a business plan in place.
Additionally, commercial lenders are normally more concerned with the property’s estimated cash flow than residential lenders are. They will want to know additional details such as what type of maintenance will be required, who will pay for the utilities, etc before approving the loan.
Next up, the costs of residential and commercial real estate are normally quite different, even if the properties are similar in area or size. The cost differences include compliance standards, materials, labor, overhead, and equipment costs.
In the case of commercial properties, the use of specialized equipment strictly for commercial construction, and the quality of workers can heavily add up to costs. Residential real estate may have significantly high costs for overhead, labor, and equipment. However, building residential real estate rarely compares to the cost of commercial as it is on a much smaller scale.
All in all, it’s up to each investor to determine which diversification strategies, investment options, and asset classes serve their growth path the best.
However, no matter in what way you choose to diversify your portfolio with real estate, one thing is for certain – the long-standing, conventional barriers that once restricted access to intelligent and meaningful diversification have fortunately been lowered.
This is empowering investors to build risk-mitigated, truly diversified portfolios like never before.
About the author:
Sachin Latawa is the Founder and CEO of Tirios, a Proptech platform for the management of Single-Family Rental Homes. Prior to starting Tirios, Sachin held the positions as Chief Financial Officer of Builders Capital, Chief Financial Officer of the Real Estate Segment of Icahn Enterprises, Director at PwC Capital Markets, M&A Vice President at Fortress Investment Group.
0 Comments