If you’re an avid real estate investor, you likely already know about the importance of diversifying your portfolio. In the stock market, diversification is fairly straightforward; you’ll want to own shares in a mix of companies from different industries and of different sizes. Index funds and mutual funds make this easy, allowing you to essentially invest in dozens, or even hundreds of companies at the same time.
But how are you supposed to diversify your real estate portfolio?
Why Diversification Is Important
Diversification is important for several reasons. Notably, if all your funds are consolidated in a single investment, you become vulnerable; a single downturn or unexpected loss could disrupt your entire strategy. By contrast, diversified holdings equalize your risk, preventing any one source of loss from ruining you.
Diversification can also help you see higher returns, especially over the long term, since you’ll earn the benefits of many types of growth simultaneously.
While it’s a good idea to diversify your entire investment portfolio (including assets like stocks, bonds, and commodities), for this article, we’re going to focus exclusively on diversifying your real estate portfolio. How can you accomplish this?
How to Diversify Your Real Estate Portfolio
There are many solid ways you can diversify your real estate portfolio:
Get more units (and properties). The standard approach is to invest in more units. If you only have one single family rental property, a vacancy will instantly disrupt your cash flow. But if you have a total of 12 units spread across several different properties, a single vacancy is only going to cost you 8.3 percent of your income. Even if your units are very similar, this is a form of diversification—but we can diversify further by choosing different types of units.
Avoid using your own money. Though not a direct form of diversification, avoiding using your own money will lower your total risk and open the door to more diversification opportunities. Taking out loans, crowdfunding, and partnering with capital investors can all help you get access to more spending power—and more types of properties—than you could with your own money. Plus, if something goes wrong, you’ll have less of your personal net worth at stake.
Buy at different times. Stock investors use a strategy called dollar cost averaging (DCA) to reduce the volatility of their investment purchases. With it, they commit to purchasing a given asset (in this case, shares of stock) at different pre-defined intervals, rather than all at once; for example, rather than investing $12,000 at once, they’d invest $1,000 at the first of each month for 12 months. This prevents them from buying at an exceptionally high price point, and averages things out. Real estate investors can partake in a similar practice by buying property at different times.
Invest in different areas. An easy way to diversify your real estate holdings is to invest in many different geographic areas. Different cities have radically different real estate markets; while one may be flourishing, another nearby could be promising in the future, but currently dragging. Eventually, those markets may flip. You can get the best of both worlds by investing in both areas.
Mix up commercial and residential property. New real estate investors focus heavily on residential properties, since they tend to be simpler investments, but as your portfolio grows, you may want to consider buying commercial property. Commercial and residential properties have different advantages and disadvantages, essentially balancing each other out.
Seek both short-term and long-term plays. Short-term plays in the real estate market allow you to take advantage of house flipping, or hot rental markets, in the span of a few months, while long-term plays sometimes require you to wait for a neighborhood to grow over the course of years. Long-term plays are stable, and provide great returns, but they’re bad for short-term cash flow. Diversify your holdings by including some of each in your overall portfolio.
Rely on budget and luxury properties. The types of people interested in renting low-cost units and luxury homes are very different, and present different types of risks. Low-cost housing will always be in demand, and in recessions, demand may only grow; but at the same time, you’ll face higher credit risks. Luxury properties, by contrast, tend to attract wealthier, more reliable tenants, but demand for those properties may subside during hard economic times. Try to include some of each in your portfolio.
Add new sources of income. Many landlords try to increase their total income by raising rent, but this can also work against you. Instead, make a move to diversify your income by finding new sources of revenue. For example, if you own a large rental property with lots of units, you could add coin-operated washers and dryers, or vending machines in a common area. You could also invest in additional parking space or storage space, which your tenants could use for an additional monthly fee. It’s an easy way to diversify your income from a single rental property.
Sink cash into REITs. If you want to get exposure to a broader real estate market, but you don’t want to deal with the hassle of buying a physical property, you could always invest in real estate investment trusts (REITs). These assets allow you to invest in property indirectly, and while you may not see the same returns as you would as a solo investor, you also won’t face as many risks.
Be prepared to adjust. Portfolio diversification isn’t a one-time process; it’s a management strategy. Be prepared to adjust your holdings on a regular basis, analyzing your personal risk and changing the types of properties you own accordingly.
Are you interested in rebalancing your real estate portfolio with the acquisition of a new property? Or do you need help managing your existing holdings? Contact Green Residential today for a free analysis, or for help looking for new properties in the Katy, Texas area!