Tips for Diversifying Your Real Estate Portfolio
Renters Warehouse Blog
The idea behind diversification is simple: to lower the risks that are involved with putting all of your eggs in one basket.
But while the concept is easy enough, taking steps towards diversification can be challenging. We tend to be creatures of habit, and when we find one investment that’s profitable, we tend to stick with it. But hedging everything on just one investment can be risky.
For this reason, it’s a good idea to look to diversify your investments. How much? That depends. Some experts recommend allocating 15-30% of a portfolio to real estate, but the exact level of diversification that you’ll want to achieve will vary, depending on your investing style, preferences, and risk tolerance.
Still, since returns from traditional investments like shares and bonds are typically not correlated to real estate returns, adding some SFR to your portfolio can be a great way to diversify and ensure that you’ll still be able to generate returns, even if there’s a downturn in the markets.
“Low correlation of real estate returns with returns of equities and bonds are typically the key argument for including real estate in a mixed-asset portfolio. This is especially the case for private real estate investments, as public vehicles tend to correlate strongly with the general stock market.” (Norges Bank, 2015)
When done right, diversification can be a valuable part of a risk reduction strategy. When you spread out your capital among different investments, you also spread the risk and can help to increase your chance of consistent returns, or, at the very least, minimize the risk of a total disruption in income.
One of the great things about real estate is that it’s tremendously versatile, and can fit well within almost any diversification strategy. It can be used to diversify a stocks-and-shares-heavy portfolio, and for those who’d prefer to invest primarily within real estate, it even offers a level of diversification within the sector itself. So, for example, instead of just investing in one type of property, in one location, you could spread the risk and branch into different geographical locations, or even different types of property.
With this in mind, let’s take a look at some tips and strategies for diversification, and creating a balanced real estate investment portfolio.
Tips for Diversifying Your Real Estate Investments
Residential and diversified real estate investments provide an average return of 10.5%. While this figure changes depending on the location, the type of property in question, and localized market demand; it highlights how real estate can be a great investment opportunity.
Whether you’re looking to diversify from an equities-heavy 401(k) or other retirement fund or hoping to diversify within real estate itself, here are some tips for balancing out your real estate portfolio.
Invest In Different Markets
While many investors get started in their own backyard, once you start to grow your rental portfolio, you may want to think about expanding into different markets. This can help to protect you from localized economic downturns, or problems that are isolated to one housing market.
“I bought 15 properties in my home city of Baltimore,” explains G. Brian Davis –landlord and personal finance expert in his article on Bigger Pockets. “I’m down to just one property there, and I wish I didn’t own that either.”
“Between anti-landlord regulation, a corrupt local government, low-quality tenants, and poor economic fundamentals, I will never buy property there again,” he continues. “But it’s what I knew when I first started investing. So I had almost no diversification in my real estate portfolio, and I suffered huge losses as a result.”
Tips for Identifying an Emerging Market
Thinking of diversifying outside of your own local market? This can be a great way to help insulate your income against localized downturns. For example, if a key economic industry takes a hit, owning properties elsewhere means you’ll be less affected.
When looking for additional markets to invest in, you’ll want to look for signs of an emerging market. That’s where you’ll find the best appreciation rates, and higher rents as well. Pay attention to secondary markets, here are some that are warming up.
Here’s a look at some things to look for:
- Population Growth: First up, you’ll want to look for population growth. Then, you’ll want to find out what’s causing people to move in. Are they long-term residents? Will they be looking to rent? A significant development could be a good sign. It’s also a good idea to get in touch with someone who has boots on the ground to get their thoughts on what’s behind the population growth. An investor-friendly real estate agent may be able to fill you in on the factors driving the population growth, or check out forums like the Bigger Pockets Forums or Reddit (r/realestateinvesting) to share your questions and see what other local investors have to say.
- Employment: Jobs are key to sustainable population growth. Before investing in an area, check to see if there are good employment prospects there that are drawing people in. If you see an Amazon Distribution center that’s moving in nearby –that’s a sure sign that there will be jobs, and increased demand for rentals. A major company like Amazon will have done their research and will be setting up there for a reason.
- Building Permits: Another thing to check is the number of building permits that are being pulled. A high number is usually a good sign of development, but watch out for a surplus. The area needs to be able to absorb the supply.
- Absorption Rates: How quickly are units renting? Locations with a lot of empty units could be a sign that things aren’t moving very quickly, allowing you to gauge demand.
- Affordability: Affordability is an important factor as well. Weigh up the median annual income and compare it to the median annual rent. If rent is higher than one-third of their income, then tenants may struggle to afford it.
Tip: Once you’ve found a promising area, head over to the Renters Warehouse Research Center to find metrics to help you assess housing markets. See population changes, employment rates, housing appreciation rates, and more.
Consider Different Types of Rental Property
There are some distinct benefits to focusing on just one type of rental, or properties in just one market. The main one is experience: when you dial in on one aspect of investing, you gain an advantage over inexperienced investors who may not be as knowledgeable on the ins and outs of an investment or even the local area.
However, branching out into different types of rental properties is another way to diversify. For someone who’s interested in learning about other types of real estate, it can be a great opportunity.
Here are a few different types of rentals to consider:
- Single-Family Rentals (SFR)
Single-family rentals can be a great investment, and while they’ve long been the realm of everyday investors, in recent years, have grown in popularity with large-scale institutional investors as well. These properties are relatively easy to get started with, as they’re usually more affordable than their multifamily counterparts. They also make it easier to diversify; you can easily purchase properties in different markets to help spread your risk.
- Multi-Dwelling Units (MDU)
Multi-dwelling units (MDU), also known as multifamily housing appeals to many investors because they have the potential to generate more cash flow than SFR units do. This type of housing refers to everything from duplexes and triplexes to apartment buildings. These investments often have higher tenant turnover rates than their single-family counterparts, although in many primary and tertiary markets they also tend to be in high demand, and you may have a larger pool of prospective tenants to market to. Just do your research ahead of time to accurately gauge supply and demand.
- Commercial Properties
While commercial real estate is an entirely different ballgame than residential real estate, it can present a good opportunity for investors who are looking to diversify. Keep in mind, though, that commercial buildings tend to be at-risk in times of economic uncertainty. If the occupants that you’re renting to are in an industry that’s experiencing difficulty, you could end up with a vacancy.
Look to Diversify Your Funding
Yes, you can diversify your funding sources as well. While many investors assume that it’s best to use their own funding for investment properties, there are some key benefits to using other people’s money, or obtaining a loan from the bank. For one thing, financing your rentals allows you to employ the concept of leverage. This means using borrowed capital to increase your potential profits. Using the bank’s money in addition to your own makes yours go farther. So instead of using your cash to buy just one property, and experiencing appreciation and cash flow on that, you’ll be able to invest in say, five properties (if you make a 20% down payment on each one), benefiting from significantly higher rates of appreciation and cash flow.
Plus, you can also reduce your risk with this strategy as well. If a property ends up sitting empty for a month or two, due to a natural disaster, unexpected vacancy, or necessary upgrades –you’ll still have cash flow from the other properties rolling in.
Consider an REIT
Another way to diversify your investments is with an REIT. An REIT allows you to invest less than you’d need to get started with your own properties. This investment option also allows you to take a hands-off role with management as well –and is a fast and easy way to invest. However, while this approach offers a level of diversification from equities, REITs are more correlated to the stock market than private real estate investments are, which means you could be exposed to the same risks as investments that are tied to the stock market. Learn more about REITs.
Risks With Diversification
Yes, there is a certain level of risk with almost everything, even diversification itself.
While diversification means that you’ll gain a level of protection from localized risk factors, one of the main risks of branching out is inexperience. You won’t have specialized knowledge of that new investment or specific market like you would if you stuck within your area of expertise. This doesn’t mean that you shouldn’t venture out or look to diversify, but it does mean that you’ll need to take the time to prepare first. This means expanding your knowledge of different properties or housing markets.
Keep in mind too, that you could always run into unexpected problems when dealing with unfamiliar markets –so make sure you research the area in question carefully, and talk to local experts –real estate agents and property managers, if you’re going to be branching out into a new market.
At the end of the day, diversification is always worth considering; although the level of diversification that you should employ and the strategies that you’ll want to opt for will vary, depending on your investment goals, investment style, and preferences. Before you start, make sure you clarify your investing goals, confirm the level of energy and time that you have to devote to new prospects, and then make a plan. With the right approach and careful strategy, you’ll be able to build a balanced portfolio, and in turn, reduce risk.
Are you looking to diversify your investments? Ready to add SFR to your portfolio? See: Tips for Success From Experienced Investors. Get valuable, first-hand information from people who have turned their investment dreams into a reality.
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