Table of Contents
- Concept of Diversification
- Why Diversification is Important in Investments
- Real Estate as an Asset Class to Diversify
- How to Diversify Within Real Estate Investments
a. By Sectors (Residential, Industrial, Commercial)
b. By Geography (City, Countries, Region)
c. By Strategies (Core, Value-Add, Opportunistic)
- Specialisation vs Diversification
- Sample Basket of Real Estate Investments
Concept of Diversification
Diversification is a commonly used investment strategy, defined as the mixture of a variety of investments within an investment portfolio. The aim of diversification is to spread out investments across different asset classes, sectors, and strategies so that a downturn in a particular area is less likely to impact the portfolio as a whole.
Examples of different asset classes are stocks, bonds, exchange-traded funds, and real estate. An investor can further diversify within each asset class, for example for real estate, an investor can invest across various geographical markets, investment strategies and property types.
Why Diversification is Important in Investments
Diversification is a key part of investing as it reduces the volatility and risk of loss in an investment portfolio over the long run. Having a diversified investment portfolio generally yields higher risk-adjusted returns in the long run compared to a non-diversified portfolio, and is perhaps the most important component of reaching long-range financial goals whilst minimising risk.
Real Estate as an Asset Class to Diversify
Real Estate provides investors with the ideal opportunity to diversify their assets, due to the asset class’s low correlation with conventional equity investments. Furthermore, there are a myriad number of ways in which assets can be diversified within real estate itself, such as by sector, geography, or strategy.
Research published in the Journal of Real Estate Research has shown that diversification through real estate can reduce risk by 60% - 94% across the United States and European markets.
How to Diversify Within Real Estate Investments
By Sectors (Residential, Industrial, Commercial)
Residential properties are any properties used for residential purposes and can range in size from a single unit or house to large apartment complexes. Residential real estate has a relatively steady demand due to the need for housing.
Single-family residential properties and multi-family residential properties, such as duplexes, triplexes and fourplexes, are smaller types of residential real estate that can still generate significant returns for investors. However, investors who have more funds can look into larger residential real estate options such as apartment complexes or condominiums.
Residential property investment typically involves renting out the property to generate rental income from tenants. However, investors should conduct their research and ensure that the property has enough demand to generate rental revenue.
Residential properties do have a degree of risk involved, since they tend to have shorter lease lengths than industrial or commercial properties, averaging at about 12 months.
Industrial real estate is any property that is used for industrial purposes, such as manufacturing, storage and production. Industrial properties include factories, warehouses or data centres.
Industrial properties typically have longer lease lengths than residential properties, since industrial tenants are more willing to agree to longer leases of up to 10 years, increasing the security of the investment for investors. These leases also tend to be net leases, where the tenants cover some of the property expenses.
Industrial properties tend to be larger and require higher upfront capital investments, making them less accessible to individual investors. However, the higher rental rates associated with industrial properties means that they also have the potential for higher yields, typically around double that of residential properties.
Commercial real estate refers to real estate that is used mainly for commercial or business purposes. Some examples of commercial properties include office buildings and shopping malls.
Commercial properties typically have a higher income potential compared to residential properties, with yields typically between 5% and 10%. Leases for commercial properties also tend to be longer than residential properties, with an average length of 3 to 5 years. Commercial properties also tend to use net leases such as double net leases or triple net leases instead of gross leases.Sign Up at RealVantage
By Geography (City, Countries, Region)
The market in which the property is located can also have an impact on an investment portfolio’s diversification. Market selection holds high potential for diversification and is an important part of the real estate investment process.
Institutional investors tend to seek out risk-adjusted returns on their investments, with a focus on diversifying their portfolio. Therefore, most of these investors tend to invest across different markets to avoid concentration risk.
Smaller markets tend to attract less investors, while deeper markets have higher potential for diversification, even within a single country or city. For example, an investor can further diversify real estate investments by differing countries, followed by differing cities, and then by regions within these cities. By diversifying real estate investment through different markets, the investor can reduce their losses in the event that an event affects the performance of a particular market.
By Strategies (Core, Value-Add, Opportunistic)
A core real estate investment typically holds lower risk as they are usually in good condition and have low vacancy rates, generating stable cash flows for the investor. Properties in a core strategy usually follow a buy and hold model, whereby the property is bought and held to generate returns in the form of rental income, rather than focusing on capital appreciation.
A value-add real estate investment is typically higher in risk compared to core investments, since the property tends to be performing below its potential and requires physical changes such as renovations or maintenance to improve the quality of the property. The property may also require a change in property managers if it is holding back the property’s performance.
After value has been added to the property, it is leased out at higher rates and then marketed on its upgraded basis to potential buyers. While this strategy entails more work than the core strategy, it has the potential to generate significant returns for the investor through rental income, as well as the appreciation in the property’s value.
Opportunistic real estate investments take advantage of underperforming properties which are generally purchased at a lower cost, such as distressed assets or undeveloped land. Existing property may require significant renovations or redevelopments to maximise returns - this strategy involves “flipping” the property, where the investor purchases the property for a lower price, then adds value to the property and sells it for a significantly higher price. Opportunistic investments also include greenfield development deals, where an investor would purchase an empty plot of land and develop a building on it based on market demand.
Since most of the returns on a property using the opportunistic strategy are through capital appreciation, investors are able to obtain an IRR of above 15%, although the risk of investing in an opportunistic property is also correspondingly higher.
Specialisation vs Diversification
Specialisation is a contrasting investment strategy, whereby investors focus on a particular asset type, using a proven strategy in the hopes of repeated success in their investments. In real estate investment, this typically involves investors investing in a particular property type and using the same strategy for all their investments, specialising in that particular investment area.
However, specialisation holds a significantly higher risk than diversification, since a downturn in the specialised investment market may cause losses throughout the specialised investment portfolio, leaving investors much more vulnerable to changes in the market.
Diversification protects investors from this risk, meaning that a loss in one investment within the portfolio is less likely to equate to a net loss in the portfolio overall. However, both specialisation and diversification have their advantages and disadvantages. Investors should consider what they want out of their own investment portfolio and select their investments accordingly.
Sample Basket of Real Estate Investments
Example of Diversified Real Estate Investment Allocation over Sectors
Example of Diversified Real Estate Investment Allocation over Strategies
Example of Diversified Real Estate Investments Within a Country
Overall, diversification is a key part of reducing risk in an investment portfolio. Real estate allows investors to diversify their portfolio even within a single asset type through a combination of different sectors, markets and strategies. However, diversifying assets requires a degree of existing knowledge about the property market and investors may need to consult with experienced real estate professionals before entering into an investment.
RealVantage is a co-investment platform run by experienced professionals in the real estate industry. RealVantage allows investors to invest across the full real estate spectrum, with opportunities around the world and in various strategies and property types. Investors can select the property they wish to invest in with full transparency on the investment approach, guided by advice from expert investors.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.