Why Diversification Is Key in Real Estate Investing
By Michelle Clardie on 08/25/2023.
Reviewed by Dan Gatsby.
Diversification is critical in creating a well-balanced investment portfolio. A diversified portfolio is in a better position to ride the ups and downs of normal economic cycles, as well as unexpected bumps along the way.
What is Diversification and How Does Diversification Mitigate Risk?
Diversification simply means spreading your investments across multiple assets of different types. This way, if one asset fails to perform, your other assets can keep your portfolio profitable.
Diversification is most commonly associated with stock market investing. You can have one investor, Investor A, who invests in a single company’s stock, while another investor, Investor B, spreads their capital across stock in multiple companies. If Investor A’s stock tanks due to poor decisions within that company, they could potentially lose everything; all their capital was in that one basket. But, even if Investor B holds some of the same company stock that tanked A’s portfolio, Investor B’s portfolio is protected by the other companies that are holding stable.
The same principle holds true in real estate investing. When you diversify your real estate holdings, you’ll be protected against unexpected changes in market conditions. And, because real estate is a low-risk investment, you’re further mitigating the risks associated with investing.
Diversification in Real Estate Investing
There are a number of ways to practice diversification in real estate. Here are three specific ways in which you can diversify your real estate portfolio.
1. Diversification by Property Type
Purchasing real estate directly is still one of the most popular methods of property investment. And choosing properties of different types can make your portfolio more diverse.
A real estate investor can choose from different property types, such as
Residential real estate, including single-family homes, small multi-family developments, and even house hacking (in which you generate passive income from your own home by renting out spaces on the property).
Commercial real estate, including retail spaces, medical office facilities, and apartment buildings with five or more units.
Industrial real estate, including self-storage facilities, warehouses, and manufacturing plants.
Because each of these asset types handles changing market conditions differently, holding a stake in multiple property types is a solid way to increase your diversification in real estate.
2. Diversification by Geographic Location
Real estate is highly localized. A housing market in Southern California can be among the best cities to invest in real estate, while one in rural Illinois can be among the worst. And these local markets can shift from hot to cold and back.
Take San Francisco, for example. For decades, property values skyrocketed. Then, in the 2020s, the local real estate market became over-priced. Suddenly, companies and individuals alike were leaving the city in search of more affordable property. In this case, having all your real estate holdings in SF could result in heavier losses than if your holdings had been spread across different regions.
3. Diversification by Asset Class
Buying properties isn’t the only way to invest in real estate. There are several methods of investing in real estate without buying property. And putting some of your capital into these other real estate-related asset classes can further diversify your portfolio. Consider asset classes like
Tax liens, which are interest-bearing financial instruments received when you pay off a property tax debt on behalf of the property owner.
Hard money loans, which are high-interest, short-term loans you can issue to other real estate investors (typically home flippers).
Private equity funding, which is when a private equity fund manager pools capital from an exclusive group of investors and chooses a development to invest the total fund amount in on behalf of the entire group. Typically reserved for well-connected high-net-worth individuals, private equity comes with greater risk, but can also provide strong return potential.
Not only do these asset classes help you diversify your portfolio, but they are also typically more passive than purchasing properties directly. So you can enjoy some of the financial gains of real estate investing without the time, skill, and analysis required when owning a property on your own.
Specific Strategies for Diversifying a Real Estate Portfolio
There are several practical ways to diversify your real estate holdings. Here are three of the best investment strategies to consider for quick, easy, and effective real estate portfolio diversification.
1. Investing in Real Estate Investment Trusts (REITs)
REITs are companies that invest in income-generating real estate.
When you buy a share of a REIT, you’re essentially investing in every property owned by that REIT. Different REITs offer different levels of diversification. Some focus on a single property type (like commercial or industrial), while others might focus on a specific region. The more diverse your chosen REIT’s holdings are, the more diverse your portfolio is.
It is important to note that investors have no input on which assets are owned by the REIT. The REIT can acquire new properties and dispose of them without investor approval. In some cases, it might even be difficult to tell which specific properties are owned by the REIT.
Invest some time in researching REIT investing to decide if this is the right investment decision for you. And compare many REITS before deciding which REIT(s) you’ll invest in.
2. Fund Investing
In today’s stock market, it is quite common to buy shares of “funds” rather than individual stocks. A fund is a pre-made bundle of individual stocks. When you purchase a share of a fund, you’re essentially purchasing partial shares of multiple companies.
Fund investing is not limited to real estate, but you can choose funds that focus on the real estate market. And there are several types of funds to choose from as well. Here are some of the most common:
Index Funds. Index funds are groups of stocks tied to a specific market index. For example, The Vanguard REIT Index Fund follows the MSCI US REIT Index, which tracks American equity REITs. The performance of this index fund depends entirely on the performance of American equity REITs. Note: The Vanguard REIT Index Fund is an example only, not necessarily a recommendation.
Mutual Funds. Mutual funds are professionally managed funds. This means that a fund manager hand-picks the stocks and/or bonds that will be included in the fund. This level of management comes with higher fees than a passive index fund, but may not provide better returns.
Exchange-Traded Funds (ETFs). ETFs are very similar to mutual funds with one important difference. Rather than trading at the end of the day, as mutual funds do, ETFs can be traded on-demand whenever the stock market is open. This gives investors more control over the timing (and therefore the trading price) of their purchases and sales.
3. Investing in Crowdfunding and Syndication
Real estate crowdfunding and real estate syndication are very similar investment models in which individual investors pool their funds to purchase real estate through an online investment platform. Investors can buy into short-term projects, like single-family home flips, or long-term deals, like multi-family rental properties.
While there are some minor differences between real estate syndication and crowdfunding, both models offer the benefit of low minimum investment amounts, which allows investors to spread their funding across multiple projects rather than placing all their capital into a single property.
Let’s say, for example, that you have $100k to invest in real estate. Now, because crowdfunding and syndication are open to the public, many investors can go into the deal together. This can potentially bring shares of a $500,000 property down to just $10,000 - $25,000. So, instead of tying your $100k up in the down payment for a single property, you can split your investment across 4 - 10 different properties!
Potential Downsides of Diversification in Real Estate
While real estate portfolio diversification is generally beneficial, there are a few potential issues to be aware of.
Time and money spent on management. The more assets you have, the more time and money you will spend monitoring your portfolio. The benefits of a diversified portfolio are usually worth the extra effort and expense. But this is a factor to be aware of before splitting your capital across so many investment types that you can no longer keep track of each asset’s performance.
Over-diversification. There is a point at which your holdings can become too diversified. When a portfolio holds tool many varied assets, the underperforming assets can effectively offset the gains from the well-performing assets. This results in a portfolio that performs worse dragging down the performance of the whole fund.
Diversify Your Real Estate Investments the Right Way with Gatsby Investment
Gatsby Investment is a real estate syndication platform that allows investors to effortlessly purchase shares in unique real estate deals.
Each deal is fully vetted by our expert analysts, ensuring that only the deals with the greatest profitability potential are offered to investors. And each deal is professionally managed by our experienced team of architects, builders, designers, and managers to maximize profitability potential while minimizing any risk.
We offer multiple investor options, so you can invest as an individual, company, fund, or even under a retirement account.
