How to Diversify a Real Estate Portfolio

One of the most common pieces of investment advice is to “diversify your portfolio.” Essentially, that means holding a variety of different kinds of assets and getting exposed to different markets so you have a smaller risk profile. In the stock market, this means investing in stocks of companies from a variety of different industries and representing many different sizes and approaches.

But how are you supposed to diversify a real estate portfolio?

Why It’s Important to Diversify

Let’s start by explaining why it’s so important to diversify your real estate portfolio in the first place.

• Mitigating risk. First, diversification is a way of mitigating risk. If the entirety of your portfolio is dependent on the appreciation of one building or one neighborhood, and that area suffers a catastrophic loss, your portfolio may never fully recover. If your assets are distributed across a variety of areas and sectors, a sudden unexpected loss won’t hurt you nearly as much.
• Reducing volatility. This is also a good way to reduce the impact of volatility. If there are sudden changes to the economic landscape or your local environment, you should still be able to generate consistent income.
• Maximizing gains. Over the long term, diversified portfolios tend to perform better than average. You can try and time the market and focus only on the most promising sectors, but you’ll stand to gain more if you’re exposed to a variety of different areas.

Preparing for Diversification

Diversifying a real estate portfolio isn’t quite as easy as diversifying a stock portfolio. That’s partially because real estate isn’t nearly as liquid. Transactions are bigger and they take longer to process, so you often can’t purchase new properties on a whim.

Before expanding your real estate portfolio, it’s a good idea to establish a strong foundation. It pays to have ample capital to work with – that way, you can make bigger purchases and buy and sell more freely.

It’s also a good idea to hire a property management company, if you haven’t already. A property management company will take care of all your day-to-day operations, so you can focus more on the big picture of your financial strategy.

Methods of Diversification

So how are you supposed to diversify a real estate portfolio?

There are many different viable options:

• Neighborhoods and cities. One of the most straightforward ways to diversify a real estate portfolio is to invest in properties in multiple different areas. You can start by buying up properties in different neighborhoods around your home city, then move to investing in properties in different cities altogether. That way, if one particular area takes a hit, you won’t have to worry about losing your entire portfolio.
• Single-family vs. multi-family. If you’re invested in income-producing real estate, it’s also a good idea to get a mix of single-family and multi-family homes. Multi-family homes are less susceptible to vacancy-related losses and tend to produce more income overall. However, single-family homes tend to be simpler to manage and cheaper to buy initially.
• Residential vs. commercial. Many new real estate investors focus on residential real estate, and there’s nothing inherently wrong with that. But if you want robust coverage in your portfolio, you’ll eventually need to think about commercial real estate investments. Commercial properties have a lot of advantages, and they can be quite lucrative investments if you strike at the right time.
• REITs. You may also want to diversify by investing in a real estate investment trust, or REIT. REITs are essentially companies that specialize in owning and managing income-producing real estate. It’s a way of indirectly investing in real estate, capitalizing on the benefits of a strong real estate market without owning real estate assets yourself. Oftentimes, REITs will expose you to an already-diversified portfolio of properties – and because they’re traded like ETFs or stocks, they’re highly liquid.
• Strategic function. It’s also important to consider the strategic function of each property you add to your portfolio. For example, you may already have a lot of properties focused on generating ample cash flow, so can you add properties that are more focused on long-term value appreciation?
• Beyond real estate. Of course, it’s a good idea to look beyond the real estate world to diversify your portfolio as well. Real estate is a valuable asset and a wise investment, but the market can still be volatile at times – so it pays to balance your holdings out with other assets.

Consider using a mix of these different diversification techniques to fine-tune your real estate investment strategy. Over time, you should be able to put together an ideal balance of risk and potential upside for your investment goals; just be sure to rebalance your portfolio regularly, so it remains updated for your current perspectives and needs.