Low Diversification Risk
There are multiple risks associated with investments in commercial real estate. In this article we discuss the risk of low diversification.
While some investors are drawn to the real estate market in order to diversify their current portfolio of financial instruments, there is a great potential for diversification further in the real estate portfolio. In fact, you must be aware of a low diversification risk while investing in properties. Diversification is important in order to secure the stability of your cash flow over the holding period.
For example, if you invest in a deal comprised of one asset in a certain area and only one tenant, the moment this tenant defaults on their lease, there is no rental revenue but operating expenses and debt service still should be covered, which translates into a loss. Imagine you invested in an asset hosting 50 tenants. If one tenant defaults on their lease, the income is almost unaffected. If you invest in 50 different assets simultaneously in 50 different locations and one location is affected, that is still insignificant impact to the total income on the portfolio.
So, in order to protect from loss of cash flow caused by low diversification, the following categories of portfolio diversification should be considered:
*Location. You can consider deals diversified across different locations – the more the better. This diversification can be in different neighborhoods, cities, states, regions or countries. Additionally, diversifying across different size markets would make sense for example between primary metro areas such as Chicago, Boston, and San Francisco, and secondary markets like Atlanta, Denver or Austin and even smaller towns.
* Asset Type. A good strategy would include consideration of diversifying the investment across the main asset types: office, retail, industrial, multifamily, hospitality, health care and self-storage. Some asset types would struggle less in a potential downturn, or the market for some would grow faster than for others. For example during the latest financial crisis, the industrial market was hurt heavily while self-storage actually gained in value. In that way self-storages are considered recession-proof. Also, different asset types react differently to shifts in the economy. Hospitality is the most vulnerable for example due to their very short overnight leases.
* Risk Profile. The risk profile of a deal depends on the strategy. There are four main risk categories progressing from the least to the riskiest: stable or core (6 – 10% IRR), core-plus (10 – 14% IRR), value-add (14 – 20% IRR) and opportunistic (20% + IRR). Diversifying between different investment strategies could make your real estate portfolio less risky overall.
* Sponsor. While it is comfortable to build stable relationships with only one partner, sometimes diversifying among a few different sponsors is good at least at the beginning of an investment journey. This way the risk of high sponsorship concentration is diversified. Some sponsors are more experienced than others and some provide better terms for the deal.
* Investment Period. Short-term investment periods offer more certainty from the perspective of a real estate cycle perspective since the business plan must be realized very quickly. Long-term investment periods bring lower targeted annualized returns but introduce more flexibility to the deal. Mixing the holding periods would ensure you don’t have to exit all of the investments at the same time and often a wrong time.
* Business Model. Each deal has its own strategy. This can be a property development or long-term buy-and-hold with a steady cash flow promise. Make sure you have diversified across different investment purposes if there is an opportunity to do so.
In cases of crowdfunded deals or REITs, it is relatively easy to diversify your portfolio of investment. The minimum investments are flexible here. For example, if you were to invest in a luxury apartment worth $1.2 million, the down payment for the mortgage would have to be around $200,000 + additional closing costs and fees. However, with crowdfunding you could build a well-diversified 20-asset portfolio with this level of initial capital and reduce the risk.
Proper diversification of your real estate portfolio is the key to protect your cash flow. Luckily the commercial real estate market provides an enormous amount of investment options which, with the right strategy, would almost guarantee the stability of the cash flow.