What does diversification mean in finance? How do we do it in real estate?

The answer lies within the word itself, it’s just a way of saying you’re not holding all your eggs in the same basket.

Diversification, as a definition in this sector, would be the distribution of funds within a set number of assets as protection in case of default on one or multiple. As an example, we can use the infamous indexes, like Nasdaq or Standard and Poor’s 500, indexes are a quick way of diversifying your investment amount just because an index is comprised of multiple assets.

Another way is by splitting your investment into two similar segments, like buying stock and bonds at the same time and balancing high yields with security, some of the major brokerage firms work with the 40/60 split, 40% bonds and 60% stock.

But as we are dedicated to other types of assets we must find ingenious ways of splitting money across our portfolios, so let’s dive into real estate investment diversification.

Real estate comes in many shapes and forms, thus generating different levels of risk and different amounts of return. Unlike stocks and bonds, the industry is based on geographic location, more than innovation or product demand. Real estate can generate steady yearly returns, like dividends of a stock and also capital gain after a period of time but the best thing about it is the versatility it gives us as investors.

Rental returns.

Rental returns are as old as time and very easy to explain, the process is simple, you buy a property and rent it. Usually, with residential properties you will be looking at a 100% ROI after about 20 to 30 years, that’s even a good way to set the rent price. Capital gain is a gamble tough, if you remember 2008, you will remember how the housing market dived deeper than Jacque Cousteau.

If we are talking about commercial properties, the returns are better. Average commercial properties, like offices, warehouses or store spaces will bring you your money back in about 15 years. Still, the risk is there, if earlier we referenced “08, now we have to mention the Covid pandemic that shut down stores, offices, hotels, and malls across the world.

Both cases are good, both can encounter losses. Now let’s imagine that we split the investment 50/50. True, the commercial part of the investment went down the drain, but the residential part was not that affected. This would be a case of safety in diversity.

Capital gain.

Capital gain is the profits we make upon the re-sale of the property, if the investment was good, we should make a little extra at the end of our set maturity period. If the markets don’t see irregular patterns, the price should be increased or decreased by the inflation index and have some percentage points added.

The only way to profit on a large scale through capital gain in real estate is to invest early in developing projects. Buying future real estate is an interesting investment to make, it holds risk, more than an already operational property but capital gain can reach a percentage of two figures and can be achieved in a short investment period. Imagine you would buy prime real estate in an excellent tourist destination, like Punta Cana, for $500/Sqm, let’s say that the construction takes two years. At the end of the period, you can either sell for roughly three times the price or rent for a two-digit ROI percentage. The risk is obvious, the default of the developer to finish.

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How do we split investments and profits?

Easier done than said. The idea of securitization of assets, other than stock came in the early ‘80’s and was first applied to MBS (Mortgage Bond Securities), basically you were investing in other people’s debts, and NO, this is not what cause the ’08 crash, for more on the Financial Crisis expect a detailed article soon.

Today we are able to securities anything, some use the word “tokenizing”, and it’s easier than you think. First, we need to identify the assets. We use a combination of human consultants and mathematics to determine actual price, rental income and VaR (Value at Risk). The process is fairly complicated and consists of complex mathematical formulas such as Brown, Graham, and the Monte Carlo Simulation pattern along with the detailed analysis of past and future inflation, political stability, and demand for real estate within that particular market.

Next, we bundle up the properties into SPV’s (Special Purpose Vehicles), these are specially designed companies that can issue shares directly to any buyer. Once you have bought any number of shares, you own a percentage of that company and everything it came with, including the properties.

Then, the property managers go to work and make sure that the properties within the portfolio are well maintained and generating revenue.

The process of diversifying real estate investments can be done in two ways, either the client builds his own portfolio by choosing individual properties, or invests into an existing one, either way, it’s safer.

Next time we dive into the core of the predictive software we use and detail what exactly makes it unique to the industry.