How to Build a Diversified Real Estate Investment Portfolio
Having a diversified commercial and multifamily real estate portfolio is important to potentially reduce risk and create multiple opportunities for potential income and appreciation. Diversification is even more important in tumultuous times like these. Here’s a look at how to build a diverse real estate investment portfolio.
Recent survey research by National Real Estate Investor magazine indicates that nearly 60% of high-net-worth investors are expected to increase their allocation to investment real estate in the next 12 months. Millions of Americans invest in alternative assets, including real estate. It’s an important step towards diversifying a portfolio with investments that don’t necessarily correlate with the stock or bond markets.
Once you decide to invest in real estate, the challenge is how to build a diverse portfolio.
Buying a property outright and actively managing it yourself is one way to participate in the market, but that typically requires a substantial initial investment — often hundreds of thousands of dollars to be paid at once. A downside of this approach is that you put all your eggs in one basket.
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Owning and managing real estate yourself also means dealing with the three T’s: toilets, tenants and trash. If you have the time, and dealing with all that appeals to you, it may be the way to go. Alternatively, you can invest alongside others in a diverse basket of properties. Diversification is even more important now with the pandemic and the additional risk it creates as the looming fear of further economic distress continues to cause concern.
Here are five tips to build a diverse real estate investment portfolio that has the potential to generate income and appreciation, as well as potentially withstand the shock of events, including recessionary downturns and, potentially, extraordinary occurrences like the pandemic and future recessions or even depressions. Please remember: Diversification does not guarantee profits or protection against losses.
Tip No. 1: Diversify by asset type
Investors should diversify their real estate portfolios by asset type to avoid the risk of over-concentration in one particular category of property — same as you would avoid over-concentration in any one stock. Rather, invest capital across asset types, such as industrial, multifamily housing, triple-net-leased retail, medical office and self-storage.
Tip No. 2: Diversify by geography
Similarly, investors should diversify their real estate portfolios across geography to avoid the risk of over-concentration in a particular local or regional market.
Tip No. 3: Avoid high-risk asset types
There is risk in all real estate investments, but some asset types have demonstrated that they are particularly risky, and are thus best avoided by those looking to reduce downside potential. These include hotels and lodging properties, senior housing in all its forms, and real estate used in the production of oil and gas.
Hospitality, for example, has been hit hard by all three recessions since 2000, including the 2001 recession, the Great Recession of 2008-2009 and the current recession related to COVID-19. In all three cases, the standard industry measure of hotel performance (RevPAR, or revenue per available hotel room), declined precipitously. Most recently, Marriott recorded its largest loss ever for the June 2020 quarter, reported The Wall Street Journal in August.
Senior care is another sore spot, which the pandemic has demonstrated once again. First, the population themselves often is at risk, literally. Second, operators of senior care facilities, whether residential housing, long-term care facilities or nursing homes, are subject to all manner of regulations that increase the risk associated with property operational performance.
Finally, oil and gas industry properties have proved to be as subject to volatility over the years as the industry they support. Just think about it: An oil well may or may not produce as expected; thus, the underlying real estate asset is particularly vulnerable to speculative risk. Stay clear if you can!
Tip No. 4: Consider the range of investing options
Unless you want to actively manage your investment properties and embrace the three T’s, passive real estate invests can be the way to go. There are a range of options to choose from, including Delaware Statutory Trusts (DSTs), Tenants-in-Common (TIC) properties and private equity funds, such as Qualified Opportunity Zone Funds.
A Delaware Statutory Trust is an entity used to hold title to investments, such as income-producing real estate. Most types of real estate can be owned in a DST, including industrial, multifamily, office and retail properties. Often, the properties are institutional quality similar to those owned by an insurance company or pension fund, such as a 500-unit Class A multifamily apartment community or a 50,000-square-foot industrial distribution facility subject to a 10- to 20-year lease with a Fortune 500 logistics and shipping company. The asset manager takes care of the property day to day and handles all investor reporting and monthly distributions.
A TIC structure is another way to co-invest in real estate. With a TIC, you own a fractional interest in the property and receive a pro rata portion of the potential income and appreciation of the real estate. As a TIC investor you will typically be given the opportunity to vote on major issues at the property, such as whether to sign a new lease, refinance the mortgage and sell the property.
Although TIC investments and DSTs have their nuances and differences, they often will hold title to the same types of property. While the DST is generally considered the more passive investment vehicle, there are some circumstances in which a TIC is desirable, including if the investors wish to utilize a cash-out refinance after owning the TIC investment for a few years in order to get some of their equity back, which can be invested in other assets.
Qualified Opportunity Zone Funds, another option, offer benefits including tax deferral and elimination that many investors nationwide have utilized. A fund of this type can invest in real property or operating businesses within an Opportunity Zone, typically a geographic area in the U.S. that has been so designated because it may be underserved or neglected. As such, there may be a higher level of investment risk. Also, the time horizon of the fund may be as long as 10 years, which means tying up your capital for that length of time in an illiquid fund.
Tip No. 5: Remember the tax benefits of real estate investing
Real estate is arguably one of the most tax-advantaged investment classes for U.S investors. Depreciation deductions are available to all investors, and any real estate investment losses may be deductible against other income, which could potentially reduce your tax bill. Additionally, direct real estate investments — including Delaware Statutory Trusts and Tenants-in-Common properties — qualify for like-kind exchange treatment, otherwise known as a 1031 exchange, which can save investors approximately 40% on their tax bills when there are net gains on property sales.
A Sample Basket of Diverse Real Estate Investments
What might a diverse basket of real estate investments look like? Here’s one example:
Mary Smith decides to invest $500,000 into commercial and multifamily real estate with the potential for income and appreciation. She makes five investments, allocating her funds equally among these assets:
- $100,000 into an industrial distribution facility with a long-term net lease to a company like Amazon, FedEx or Frito Lay
- $100,000 into a medical dialysis center with a long-term net lease to a company, such as Fresenius or DaVita
- $100,000 into a multifamily apartment community with 300 units in the Southeast
- $100,000 into a self-storage facility in the Midwest
- $100,000 into a debt-free multifamily property with 50 units in Texas
Net-net, Ms. Smith has diversified her portfolio by both asset type and geography. She has avoided more cyclical and highly volatile asset classes, including senior housing and long-term care, hotels and oil and gas. She has made passive investments, leaving day-to-day management of the properties to industry professionals. And she has consulted with her accountant and attorney about the tax advantages of real estate investing, including 1031 exchanges.
She is well positioned for the uncertainty of the future and is aware that all real estate investments have risks, and that income and appreciation are never guaranteed. Even diversification, while desirable, does not guarantee profit or protect against losses, but it can potentially reduce risk and create diverse potential income streams and opportunities for appreciation.
