How Do I Build a Diversified Real Estate Portfolio?

Posted by Sebastian Abrigo on Sep 26, 2022

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Building a diversified real estate portfolio follows many of the same principles required to build a diversified stock portfolio. Pursuing low correlations across assets and choosing from different assets are all meant to help manage the portfolio’s overall risk — a goal of diversification. 

There’s a lot to consider when creating a diversified real estate portfolio. It’s more than just geography, cap rates, building classes, and vacancy rates. There are other asset classes within real estate to consider as well. Additionally, tax implications and liquidity concerns should factor into any real estate portfolio.

Diversification Through Asset Classes

As mentioned above, the goal of diversification is to manage overall portfolio risk. A real estate portfolio doesn’t mean only real property. Once you think outside of real property, there are many asset classes to choose from. Let’s look at some of these asset classes.

Real Property — real property means owning a structure as an investment. A single family home or an apartment building are two examples. These assets can provide monthly income and hopefully appreciate throughout the life of the property.

When selecting property, we believe it's important to choose different locations and building classes. This may help to stabilize the monthly income stream. 

Real property often requires significant capital contributions, which usually means taking out a loan. The deal structure on real property can be complex. Also, investors will have to manage these properties or hire someone to manage them, which will add to costs.

For those who can afford only one property or even none, the next few asset classes should provide some alternatives to real property. They are also in addition to any existing real property within a portfolio. 

REITs – REITs are public or private. They are funds (private) or stocks (public). Unlike real property, management is not required. A sponsor handles all management of the properties, making REITs passive. REITs can pay dividends and have the potential for appreciation.

Syndications — Some syndications are also called crowdfunding. These deals are generally offered through a website. The investor invests in a fund or a specific deal with a sponsor. These investments are also passive.

All of the above can be diversified further by residential or commercial property. Commercial property or CRE (commercial real estate) includes office buildings, warehouses, storage facilities, and more.

Real property, REITs, and syndication deals can be structured in different ways. Debt financing pays regular interest but doesn’t have any upside. If the property appreciates, debt investors will not be able to participate in the appreciation. Some equity financing deals don’t have regular payments but allow the investor to participate in the appreciation of the property.

In addition to asset classes, deal structures (debt vs. equity), and commercial or real estate, investors should also factor in liquidity.

Liquidity Considerations

Life happens, and you never know when you might need money. If most of your money is in real property, it is most likely illiquid. You can probably sell the property if you’re in a hurry but at a discount to its market value.

Publicly traded REITs are liquid. Most syndications are not liquid but generally have a known exit (i.e., property is sold and funds are returned to investors). By staggering these exits, an investor can create some liquidity. With part of the portfolio in REITs, part in syndications, and the rest in real property, an investor’s real estate portfolio can be partially liquid.

Some real estate investments strive to generate consistent cash flow. We touched on this in the previous section. Real property rentals, REITs, and syndications (debt structure) all seek to provide regular cash flows. An equity-only deal may not provide any cash flow. When considering liquidity, keep the type of deal structure in mind.

Tax Implications

Taxes are an important component of a real estate portfolio. Each of the above real estate classes has different tax advantages and implications.

Real property may be the most complex regarding taxes but also offers the most advantages. It allows investors to save on taxes through interest on loan payments and depreciation, a non-cash flow deduction.

REITs and syndications don't allow the same types of deductions. REITs pay dividends (1099-DIV). Depending on the dividend type, it may be taxed at a lower rate or your ordinary tax rate. A debt deal that pays interest (1099-INT) is taxed at your ordinary tax rate. Any payment from an equity deal is a distribution (K-1) and likely taxed at your ordinary tax rate.

The tax implications of a real estate portfolio can be complex. This is why it is best to work with a real estate tax advisor when structuring a real estate portfolio.

When building a real estate portfolio, instead of thinking about what you should buy, consider how you can build a portfolio that balances risk and returns. Assets in the same asset class can have different risk/return profiles. It depends on the deal. Pursuing a mix that fits your needs may help them balance each other out.

A real estate portfolio is also a subset of your more extensive portfolio. Within the larger portfolio there are stocks, jewelry, collectibles, etc. Is your real estate portfolio making the larger portfolio more volatile? Is it putting your other assets at risk? Those are other considerations that an investor should contemplate.

Programs that depend on tenants for their revenue may suffer adverse consequences as a result of any financial difficulties, bankruptcy, or insolvency of their tenants.

A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.  There are risks associated with these types of investments and include but are not limited to the following:  Typically no secondary market exists for the security listed above.  Potential difficulty discerning between routine interest payments and principal repayment.  Redemption price of a REIT may be worth more or less than the original price paid.  Value of the shares in the trust will fluctuate with the portfolio of underlying real estate. There is no guarantee you will receive any income. Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.  This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein.  The offering is made only by the Prospectus.

There is no guarantee that companies that can issue dividends will declare, continue to pay, or increase dividends.

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