Real estate diversification is about far more than choosing different locations and sectors to invest in. The topic is extremely deep. Location and sector-based investing are only skimming the surface. When discussing diversification with your clients, the following lists should be a minimum:
This list is not exhaustive but covers many of the most important aspects of diversification. We'll go through this list in more detail. By the end, you'll have a more in-depth understanding of diversifying your client's real estate holdings.
Real estate market diversification looks at the local market, submarkets within the local market, and trends in the national market.
A local market means investing in one geographic location. However, better diversification occurs when the client invests in other geographic locations. This can be a different town, region, or state.
For example, a client invested in Los Angeles, and Houston has good location diversification. The demographics of the two cities are also quite different, which means many different trends across both cities.
A submarket is a market within a local market. This generally refers to neighborhoods. One neighborhood on the west side of town might be composed of highly educated, high-income residents. In comparison, another on the east side of town may be going through gentrification.
The west side neighborhood means stability. The east side neighborhood can mean a better opportunity but with more risks. A knowledgeable local real estate agent is essential to understanding sub-markets within a specific area.
Sector diversification spreads a client's investments across business types. These include mixed-use buildings, retail, industrial, mini-storage, retirement homes, apartments, single-family homes, and offices.
There's much to research and understand when deciding which sector best suits a client. Knowing a sector's trends and geography and mixing the right sectors within a portfolio can lead to better stability.
For example, the office sector experiences a decline due to the pandemic, but the mini-storage sector remains strong. One sector helps offset another in this case.
Real estate investments can be diversified by investing in public and private markets. These two markets are very different.
Private investments are direct real estate, TICs, and private deals. These investments are more illiquid than public market investments. Because price discovery can be more difficult in private markets, volatility is usually lower than in public markets.
A single real estate investment fund can provide diversification if the fund invests across different sectors and locations. These different sectors bundled into a single fund means the client is getting a diversified investment. An example of this is the Delaware Statutory Trust (DST).
A syndication is similar to a diversified fund, except a single sponsor spreads a client's investment across one or more deals managed by the sponsor. In this scenario, all deals the client is invested in would have to fail before they lose their investment. However, another risk is that the investment firm could also fail. But even in that case, depending on the investment agreement, the investments may continue under different management.
Some real estate deals are equity-only, debt-only, or a mixture. An equity deal is more common than debt. Equity means the client invests their capital into a deal that allows them to participate in appreciation. There may also be cash flows from rents.
Debt deals are similar to investing in a bond. They are also generally less risky than equity deals, mainly because they sit at the top of the capital stack. That means debt investors will be paid before equity investors if the deal goes bad.
Debt investors receive regular interest payments. At the end of the investment term, their principal is returned. There is no upside participation in a debt deal.
Clients can diversify within the same sector by varying their financing structure across debt, equity, and debt/equity deals.
Adjusting positions based on economic and demographic factors will also affect portfolio diversification. As positions are removed, added, and resized, diversification will change. However, economic and demographic trends can’t be ignored, and a portfolio should expect periodic adjustments due to these trends.
Quarterly research into these economic and demographic trends can help your clients stay on top of areas that may negatively impact their portfolios.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
Risk tolerance is an investor’s general ability to withstand risk inherent in investing. There is no guarantee a recommended portfolio will accurately reflect your tolerance to risk.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.