Diversification is important with all types of investing, but so few investors in real estate discuss the true importance of diversification. There are three diversification strategies that should be considered by all investors, but real estate investors should pay particular attention to these strategies because it is not discussed often enough for people in the real estate business. The three diversification areas that real estate investors should understand and have a strategy for are Deal Diversification, Geographic Diversification, and Sponsor Diversification. Since getting caught almost 100% invested in Internet related stocks in the Dot Com stock bust of 1999/2000, my personal goal has always been to have significant personal diversification.
What is Diversification?
According to Wikipedia, diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A way to diversify is to invest in a variety of assets.
The premise behind diversification is that having a variety of investments will shield you from unwanted exposure to a particular area. The fact of the matter is that real estate diversification enables you to have exposure to different real estate asset types (e.g. apartments, office, industrial, retail, leisure, self-storage, etc.), multiple geographic markets, a variety of real estate Sponsors, and exposure to different currencies to name a few.
Over time, having exposure to multiple properties that are in multiple geographic areas may or may not provide the highest returns — those studies are not entirely conclusive. Some research shows that concentrated investments are better for higher gains while other research shows that a diversified portfolio provides better returns over the long-term. From my experience, diversification strategies in real estate are a very attractive way to earn above average cash-on-cash returns for the portfolio while also limiting any shocks that could occur in a specific market or property type. Truth be told, I also think that the strategy that suits you better has to do with your own personality.
There are a few reasons why real estate diversification works well for me. The first reason that real estate diversification works for me is that I am conservative by nature. I want to consistently earn money on the money I invest. I want to preserve the capital invested. And I want to see the potential for appreciation through increases in revenue, decreases in expenses, better management, re-tenanting, and/or refinancing.
The second reason that real estate diversification works for me is that I understand that I cannot be everywhere physically, but that I can partner with trusted people in various markets where I am not directly active.
The third reason that real estate diversification works for me is that I love traveling. I have a rule that I will only invest in markets that I like and where I have a need or desire to return to. When I am investing in a new market or even in a new property in a market that I already invest in, I make a point to see the property. I enjoy property due diligence trips. Every time I travel whether it is within the US or throughout the rest of the World, I always make a point of meeting fellow real estate professionals and looking at a variety of real estate opportunities in the market. I can typically assess very quickly now whether the market is one that I like and one that I either need to return to or would like to return to. If I do not like the market, I will not invest. If I do not have a need to return or a strong desire to return, I do not invest.
Deal diversification is the most important strategy for diversification in my opinion. It is important to have more than one investment over time. Everyone has to start somewhere and that is usually with one deal, but the goal should be to get the first deal invested in so that you build confidence and can then move onto investing in other deals. If you only have one property and something bad happens to that property or the market, you do not only have one egg in that basket.
I don’t know what the right number of deals is for you, but I like spreading out my investment dollars among more deals rather than fewer deals. As I have told client ad nauseum, I am conservative and investing smaller dollar amounts over a range of deals makes more sense to me. It also gives me more piece of mind. However, I am starting to allocate larger chunks of capital in my newer deals because I now have over 50 investments. Now that I am diversified, I now want to manage the diversification.
Having a range of investments is important, and investing in various locations that you like, and have a need and/or desire to return to is essential to your long-term real estate strategy. Geographic diversification forces you to look at important factors in each market you choose to invest such as population growth, job growth, per capita income, average and median household incomes, vehicles per day passing your property (assuming that is important to the real estate you are buying), and crime statistics to name a few.
I generally look to invest in metro markets that have more than 50,000 people although I prefer being in larger markets. I also look to invest in markets with population growth above the national average, but 1.5%+ plus year-over-year growth is a good metric. Additionally, I like to see that the market is adding jobs. Without job growth, the market can stagnate or worse yet, decline. Negative job growth will ultimately negatively impact property values. Additional date points that I track are per capita incomes, and both median and average household incomes that are above the national average. Knowing crime statistics in the area is also important, as that can be a predictor of how the property will perform in the near- to mid-term. I personally do not invest in areas with crime that is higher than the national average.
After I built up a good number of investments that I control or that I am a direct partner, I expanded my diversification strategy to include other Sponsors of real estate deals that I knew or knew of. I initially made these investments solely with self-directed retirement funds, but now I strategically diversify using a mix of self-directed retirement accounts with deferred tax status and available cash that is taxable.
Getting Sponsor diversification for me means not having all my money with one operator. As we saw and remember from the downturn, too many people had all of their money with one manager. It is good to diversify your investments among a number of trusted Sponsors. You can review the Sponsor’s track record, time in the business, whether they have given back property, been foreclosed on, gone bankrupt, ever had issues with the SEC or IRS, etc. It is your money so do not be bashful with Sponsors when you ask questions. Like in life, almost all of the Sponsors are good people who are open, ethical, and honest. It does not mean that there are not risks and that losses do not occur, however, it is imperative that a Sponsor is doing everything in his or her power to do right by the investors and to communicate actions being taken with the investors.
What am I Doing?
I am doing more of what I have always done. There are good deals in every market and every market cycle, so I am looking at, analyzing, offering on, and closing various real estate transactions in multiple markets. I am being more conservative. I am underwriting less growth in market rents and appreciation. I am also keeping cap rates flat or expanding them a bit to stress my assumptions a bit. My conservatism is making it harder to find deals, but I do not necessarily think that is a bad thing, as I want the investments I make to do well for my investors, family, and friends.
I am looking at Direct equity investment in multiple markets. I am actively looking at apartments, mixed-use, industrial, single tenant net lease deals, and medical office. I have a number of target markets that I am actively looking at, but those change depending on market research about population and job growth.
I am looking at Indirect equity investments in multiple markets where I can invest with trusted Sponsors in product types and markets that I like that I do not have an intimate knowledge of or an ability to create a team quickly. I also look at working with Sponsors who are looking at larger deals than what I undertake on my own. I am looking for large industrial properties that are last mile e-commerce sites, medical office, large market rate apartments, and self storage.
I am also looking at Debt investments in multiple markets in the US and Europe. I started in the real estate business as a commercial real estate investment banker working as a direct lender and mortgage banker for both stabilized lending and bridge lending. At this point in the cycle, I am starting to see some interesting lending options where it is possible to achieve yield at a lower risk level with moderate loan-to-value ratios. Those deals may be lower yielding than the direct and indirect equity deals that I am looking at, but I like the range of current cash flow I can achieve from both equity and debt investments, and the upside potential that I can achieve from equity investments.
What am I Recommending to Clients?
At this point in time, I recommend that clients invest broadly. This can be achieved by investing in equity either directly or indirectly, and it can be achieved by investing in debt instruments.
I recommend that clients invest directly on their own and that they invest indirectly with people that they know or that they trust.
Although there seems to be no shortage of capital for debt, and arguably not enough product to get financed, I think that it is still wise to act as a lender for select property types and investment strategies. You can generate good yield and take a limited amount of risk doing so.
In my opinion, investors work too hard trying to achieve economies of scale in one market and one product type. While I believe that strategy works, it makes investors susceptible to too many risks. What happens if there is an economic downturn that heavily impacts a particular property type? What happens if an economic downturn drives out migration from the area? From a diversification standpoint, I am a believer that most investors do not need to focus on every real estate asset type or every geographic market. Focus on property types and markets that you can become an expert in and where you have a need or desire to travel. Then accomplish further diversification by finding good Sponsors that you can invest with as a limited partner and let your extra money work for you through other qualified Sponsors.
My exercise for you is to formulate your own investment thesis. You may want to focus on certain properties in your own backyard or you may do what I do, which is specialize in investing and financing various property types in various locations. I am not here to tell you which is right for you, but you should take the time to take stock of what you like and what you want to get out of your real estate investing strategy.
Let’s continue growing our passive cash flow and net worth together!