The Importance of Portfolio Diversification Relating to Real Estate Investments

The Importance of Portfolio Diversification Relating to Real Estate Investments

June 20, 2016

One of the core principles of portfolio management is diversification. The objective is to allocate capital across a multitude of assets to minimize risk and overexposure, with the aim of acquiring a higher blended rate of return. This is in accordance with Modern Portfolio Theory, which states that overall risks can be reduced when investors distribute their capital in asset classes that operate independently of each other.

Real estate is a significant aspect of institutional and personal investment portfolios. This is because the real estate market differs from and does not correlate to bond and stock market cycles. As for the suggested limitations of allocating real estate investments, iintoo’s chairman, Dov Kotler, suggests capping such investments at 10-20% of one’s personal portfolio. Over the past decades, real estate-investment trusts have outperformed equities on an annual basis. Such trusts have strong abilities to provide inflation protection, as there is the option of increasing rent, which is more than often indexed to inflation.

There are also high levels of income return, which are associated with real estate investments on top of the property appreciation over time. These are significant reasons that contribute to long-term investment.

Diversification within Real Estate Portfolios

The principle of diversification also applies within the framework of the real estate portfolio itself. There are a range of steps to take to strategically spread out the investment risk across a number of real estate categories. The following 5 points emphasize where diversification can and should be addressed:

  1. The Business Model

One should invest via an assortment of strategies. These can include long-term scenarios of collecting a stable but predictable lower income or in new developments with a business model that provides a high upside when the property is sold with little yield during the duration of the holding period. The holding period is a significant part of the model, with a range of options available regarding exit opportunities at different stages in each project’s timeline. It is preferable to have your exits scaled across a broader timeline to avoid exiting all projects in unison, which, in essence, may happen to be a bad decision. Diversification across risk profiles is also a variant in the business model, with stable core investments in the center and allocations to higher-risk and low-risk projects as well. All are on the spectrum.

 

  1. Property Types

It is possible to diversify allocation across a range of asset classes to protect against periodic ups and downs, which may affect specific types of assets. These classes of assets include: single home, multifamily, office-space, commercial, industrial and hospitality. Attractive strategic property investment aims to acquire a stable stream of income from rent, which affects the return on investment and overall profitability. Strategic property investments include residential multifamily projects, office floors, retail properties, hotels and warehousing.

 

  1. Geographic Location

Diversification across specific neighborhoods, cities, counties and states is one way to look at allocation across various geographical regions. In addition, one can segment between gateway or primary markets like major cities vis-à-vis secondary markets. In essence, this type of diversification protects investors from localized economic lulls, as each local market is affected by an entirely different ecosystem. However, it is required to have local market knowledge prior to making investment decisions on the ground in each chosen location.

 

  1. Debt & Equity Types of Investment

In a debt investment, the investor loans money to a business or a person, and the profits from the investment are not related to the performance of the borrowing party. On the other hand, an equity investment buys the investor an asset or a piece of an asset, and the profit is an outcome of asset performance. Equity-based investments will typically have a long-term higher rate of return but are more volatile than safer debt-based investments.

 

  1. Hedging between Developers

By diversifying between multiple developers, there is a limitation to the risk associated with banking on a specific developer. Over time, after narrowing down the overall experience of years working with specific groups, one might concentrate on those that have delivered to a higher degree. Experience and a good track record are key factors in the decision-making process of which developer, provider or investment platform with which to run. It has become very popular to also diversify through real estate investment portfolios, which are diversified across multiple layers and categories.

At the end of the day, there is no single strategy to pursue within the framework of diversification amongst real estate allocations. It is imperative to keep a tab on each asset’s performance and to make the correct judgement call of switching poorly performing investments with newly diversified ones in a timely manner.

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