If you are not diversifying your investments as a real estate investor, you are treading a possibly dangerous path. To succeed in this sometimes unpredictable business, you need to have a diversified investment portfolio. In today’s piece, we are going to talk about how you can approach diversification by spreading your investments across operators, asset-classes, and geographical areas. Let’s jump right in.
Investors don’t have the same preference when it comes to location. While some like investing in their local areas, others prefer investing outside their state but within a single sub-market. Agreed, everyone has investment strategies that work for them. However, the problem with concentrating all your properties in a particular geographical location is that it makes you more vulnerable to economic and weather-related risks.
For instance, let’s say you have 15 properties that are just miles away from each other. A major earthquake can occur and destroy all these investments in one fell swoop, putting you in trouble.
Some parts of the US, like Florida, suffer from hurricane attacks from time to time, which are affecting real estate in that area. While this does not mean Florida is a bad place for real estate investors, you will be in big trouble if you invested heavily in a Floridian location and one hurricane destroys 50 percent of your properties.
Here’s another weather-related example: A big mobile home park operator would tell you that they have no issues with investing in areas prone to tornado attacks but stay away from hurricane areas. The reason is that hurricanes typically wipe out a large area when they hit. Consequently, insurance companies and government agencies are overwhelmed, so it often takes a very long time to get the damage repaired. Tornadoes, on the other hand, affect a more isolated area, so the Federal Emergency Management Agency (FEMA) can quickly come in and help. Compared to large territories, isolated areas are also easier to manage. For this reason, these operators get their properties replaced for free and more quickly in the event of tornado attacks. The bottom line is, hurricanes are more difficult to manage than tornadoes.
Other than weather-related risks, another good reason why you should diversify across various geographical locations is that each of them has its own challenges and economies. For example, if you invested in a town whose economy depends on a particular company and the company chooses to relocate, you will be in trouble. This is why job and economy diversity is one important factor you need to consider when choosing a target market.
There are also many other examples we could cite. So the point is, it’s good to have your investments spread out across various geographical locations.
Another important thing is to diversify across different classes of assets (both from a tenant and asset-type point of view). For example, you should only invest in apartments that have 100 units or more so that if a tenant leaves, your vacancy rate would only increase by 1%. But if you invest in a four-unit apartment and a tenant vacates the building, the vacancy rate would rise by a staggering 25%.
It is also good to spread investments across different asset-types because assets don’t perform the same in an economy. While some do well in a thriving economy, others perform well, or are easier to manage, during a downturn. Office and retail are good examples of asset-types that don’t perform well in an upturned economy but are not affected by a downturn – in particular, retail with key tenants, such as large grocery stores, Walgreens, CVS health, and so on. Owners of mobile homes and self-storage have no reason to worry about a downturn because that is when these asset-types perform better. For example, in the year 2009, the self-storage vacancy rate only rose by 1 percent. And this is partly due to the increase in their demand by homeowners whose properties had been seized and needed a place where they could store their items.
You would like to be as diversified as you can so that the cash flow would still be coming in whether the economy is good or bad. This is very important if you are the type of real estate investors that live off passive cash flow.
However, we don’t recommend that you invest in all asset classes. For example, you can leave out hotels and commercial space, as these assets only do well when the economy is booming but suffer when there’s a downturn.
You are giving up control for diversification when you chose to be a passive investor. In other words, you’re giving others control of the daily operations. And the chances are that you are investing with several investors, so you have minimal control over your investments. If you would be giving up control, you better be trading it for diversification. This is because there’s always a 1 percent risk when investing with operators due to the chance of fraud, mismanagement, etc. And you are putting yourself at risk by being a passive real estate investor. So, it is good to diversify across operators in order to reduce this possible risk.
People have different opinions on the maximum exposure a real estate investor should have with operators. Most investors don’t get exposed to an operator with over 5-10 percent of their capital. The same also goes for asset-classes and geography.
Even though proper diversification takes time, it is good to remember that it’s the best thing to do if you are willing to mitigate risk. The more diversified your investment portfolio is, the better. Finally, no matter how promising an opportunity is, make sure you don’t invest more than 5 percent of your capital on it. This means you should aim to diversify across 20 or more opportunities and find out the operators you are more comfortable with.
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