How To Diversify With Real Estate

In finance, portfolio diversification is the way to grow and protect your assets. Though diversification is typically understood as holding different types of investments or employing different investment strategies, it is still more than possible to diversify a portfolio with only one kind of asset...real estate assets.

Every investor knows the importance of diversification. It goes back to the adage, “Don’t put all your eggs in one basket.”

For real estate investors, diversification may seem like more of a challenge. After all, you're employing one specific strategy to achieve your goals. In many cases, you also focus on one particular type of property.

Where is diversity to be found?

Believe it or not, you can effectively diversify your portfolio while specialising in one type of strategy or asset.

In real estate investment, the chief role of portfolio diversification is to both protect and grow your wealth.

Hedging against risk

The primary function of diversification is to hedge against risk. As investors, we want to mitigate risk exposure as much as possible. Risk is inherent in any type of investment.

Reducing unnecessary risks sets your portfolio on a firm foundation.

For example, if you invest only in stocks and the stock market crashes, your portfolio will be in jeopardy. Similarly, investing only in one real estate market and facing a market crash, natural disaster, or other local crisis can negatively impact your portfolio. When your portfolio is impacted, passive income and appreciation are also impacted.

Diversification effectively allows you to weather these unexpected downturns and circumstances. By sustaining your cash flow and net worth through multiple holdings, you can create a barrier and mitigate some of the risk.

Scaling for wealth

Success in any kind of investing demands that we grow. Portfolio growth is essential for building real, lasting wealth. When we scale our portfolio through diversification, we create multiple avenues that generate wealth. Not only does this increase our ability to acquire new assets for a growing portfolio, but it allows us to continue earning even if one of our assets is struggling.

While there is a justified emphasis on scaling (and thus diversifying) one’s portfolio, investors must be wary of scaling too much too fast. No investment strategy, diversification included, will fully eliminate real estate investment risk.

Investors run the risk of hurting themselves if they over-extend their assets in the name of diversification. Scaling too quickly can be overwhelming.

Scale as you can and are comfortable with. Prioritise solid, stable investment opportunities over high-risk ventures, especially in the beginning. While it may not be “exciting,” it will give you the foundation necessary to build wealth, manage greater risks, and succeed in real estate investment. 

Consistency

The more investments you hold, the less one investment will skew your outcomes. In the long term, a diverse portfolio gives a more clear and consistent view of your growth and overall performance.

Specialisation

Specialising in certain types of properties such single-family rental (SFR) properties and focusing your time and energy on certain data points such as median housing price, market growth, job growth, industry growth and other key demographics will greatly reduce the risk of making mistakes when strategically selecting your next acquisition.

Cash flow & appreciation

While investors benefit from rentals in a number of ways, the most prominent is the combination of cash flow and appreciation. Real estate properties not only generate monthly cash flow, they also, like most real estate assets, appreciate over time. As an investor holds the property, both increase. Once investors pay off any existing mortgage balances (often with rental payments), cash flow only grows.

Leverage

Few investments benefit from leverage like real estate. Leverage is the ability to use other people's money(mostly from banks) to acquire assets. In the case of real estate, this means acquiring bank loans in the form of mortgages. Rather than putting up €100,000 of your own money to buy an asset that generates passive income, you can put up €20,000 of your own money as a down payment while the bank pays for the rest.

While outstanding mortgages are nothing to take lightly, this strategy allows investors to scale more quickly while using less of their own capital. Leverage facilitates increased portfolio diversification.

Hedging against inflation

Real estate is known to be a hedge against inflation. These kinds of investments are known for retaining or increasing their value in the face of fluctuating currency values. Its low volatility combined with its inflation hedge makes it a great option for diversification against, say, stocks, which can be highly volatile.

Exit strategy options

Every investor needs an exit strategy. One major advantage of certain types of real estate assets is the investor’s increased options for resale. A multifamily or commercial property has a limited pool of potential buyers, whereas a single-family property can be sold to potential homeowners, other investors, or back to an investment company.

Tax advantages

Real estate can be highly incentivised by the government through tax benefits. Operating expense deductions, accelerated depreciation, mortgage interest, pass-through deductions, management and repair fees, property tax and insurance deductions … just to name a few.

There are also tax-deferral strategies. Always consult a tax professional who has experience dealing with real estate investors to ensure that you maximize your tax advantages.

Can you diversify if you only invest in one type of real estate?

A portfolio is most diversified when it has a variety of investment types. However, an investor’s ability to diversify is often limited by their assets and experience. A new investor, for example, probably shouldn’t jump right into buying commercial or industrial real estate.

Residential real estate is the best entry point for new investors.

Whether you’re a new investor looking to diversify your portfolio or someone with more experience, know that it is possible and necessary to diversify a portfolio of residential real estate.

There are two primary ways to do this.

#1 : Increase your properties

The simplest way to diversify is to acquire more properties. In the instance of a buy-and-hold investor, more properties mean more streams of income, more appreciation, and greater net worth.

Should you encounter a vacancy or emergency, you will have other properties that can offset this loss. Instead of earning nothing one month as the owner of a single property, maybe your earnings are reduced only by a fifth, a tenth, or even less, depending on how many properties you own.

#2 : Vary by location

We all have the saying burned into our brains: location, location, location. While we most often think of this in terms of the best place to buy for value and future appreciation, it also relates to portfolio diversification. Spreading your properties across multiple markets helps mitigate economic risk. We can see a prime example of this if we look back to the Great Recession.

Many primary, over-inflated markets bottomed out, whereas more evenly, modestly appreciating markets dropped with less severity, and thus bounced back more quickly.

Investing in multiple markets allows you to focus on different price points, demographics, and economic conditions. As these fluctuate and change over the years, you can rest easy knowing that a downturn in one market doesn’t mean a downturn for your portfolio.

Naturally, you have more options for diversification if you also pursue different types of properties. You can invest in stocks, bonds, syndications, and lending. All of those help them to diversify.

Quality over quantity

Proper diversification comes from carefully vetting and weighing your investment opportunities. Rather than investing in 56 sub-par properties, you can find more success and stability by investing in 10 great properties that fit your vision and long-term goals.

A diversification strategy won’t reduce your risk if all you invest in are high-risk assets. This is why you need those core investments first. The investments you can rely on to generate consistent value.

Scale as you can and are comfortable with. Prioritise solid, stable investment opportunities over high-risk ventures, especially in the beginning. While it may not be “exciting,” it will give you the foundation necessary to build wealth, manage greater risks, and succeed in real estate investment.

Conclusion

Diversification within real estate is achievable but should never be at the cost of your real goals. Don’t seize an opportunity just to diversify if it is not a type of property or strategy you want to be a part of. Assess your short and long-term goals to ensure that the opportunities you pursue fit.

As a buy-and-hold investor, you should be looking at a seven- to 10-year horizon. Avoid unnecessary loss and risk through careful, thoughtful scaling that is consistent with your vision for diversifying your portfolio and succeeding as a real estate investor.