Diversification: Why Every Real Estate Investor Needs It

Real estate can seem like a far more stable investment than the stock market. As a physical asset, it’s far less likely to disappear overnight than a stock investment can. But despite these benefits, it’s not entirely free of risk. Diversifying your property portfolio is the way to protect your investments and ensure they see steady growth. Today, we will show you how you can do that and why it’s so important.

It’s often been said that nothing makes for a safer buy than a house. While that may be true, some houses make for a safer investment than others.

What Is Diversification?

Strictly defined, diversification is an investment strategy that uses various asset allocations to reduce risk and improve the performance of an investment portfolio. Essentially, it’s a way to protect yourself against sudden changes in one market area. If home values start to plummet in one geographical location or asset class, a savvy investor can still pull through so long as enough of their other holdings are doing well.

The keyword here is a correlation. This is the measure of how related one investment is to another. Those investments that move in the same direction, to the same degree, and simultaneously are said to have a perfect positive correlation. Those that move in the opposite direction have a perfect negative correlation. There are very few investments that share a perfect correlation. But you will see a lot with high, low, or no correlation. Generally, any portfolio with an increased number of low or no correlation investments is highly diversified.

Keep in mind that correlation is not set. It can fluctuate across both the short and long term. This is important when it comes to the question of volatility. Any period of high market volatility, like a downturn, signals that your investments should be following the market trend.

How to Diversify Your Portfolio

Any experienced investor will tell you there is no one-size-fits-all approach to diversification. What you choose for yourself depends a great deal on what your goals are. While diversification is meant to reduce risk, it can’t eliminate it. For instance, someone looking to build a stable set of investments to cover their retirement will have a far lower risk tolerance than a short-term investor looking to make a quick buck. Less risk means less volatility, which makes earnings more predictable.

Below, we’ve covered the five main strategies for diversifying a real estate portfolio.

1. Asset Type

Real estate comes with a huge variety of asset classes you can invest in. There are condominiums, single-family homes, multi-family properties, retail, office space, etc. There’s great potential for growth in any one of these sectors. By investing in a mix of them, you can better protect yourself against broader economic shifts that affect one asset class more than the others.

2. Geographical Area

Location is everything in real estate and how well an asset is doing depends significantly on its location. Just as one city might be experiencing a boom, another one not far away could be going through a bust. To protect against these regional ups and downs, investors need to have many investments spread across different geographical areas.

3. Property Class

Property class refers to the quality of an individual investment. It can usually be broken down into Class A (high-end), Class B (mid-range), and Class C (low-end). These ratings have no strict standards and serve only as communication between investors when discussing different quality levels. Savvy real estate investors will know the importance of having a mix of these classes to cover against changes in the market. When times are good, you’ll see people upsize to larger, more luxurious homes. They’ll usually downsize to a smaller, more affordable home when times are bad.

4. Holding Strategy

When you first purchase an investment property, you must decide what your holding strategy will be. Some properties require a long-term buy-and-hold strategy, and others might be better suited to the BRRRR strategy (buy, rehab, rent, refinance, repeat). By diversifying the number of investments you have with different holding strategies, you can better protect yourself against downturns in one market area.

5. Active vs. Passive Investing

Good portfolios will mix active rental properties (places you own and manage yourself) and passive real estate syndications (jointly owned group investments). While most active rental properties tend to be smaller residential homes, group investments tend to be larger commercial properties like apartment buildings. Having your feet in both types lets, you build your investments while also developing contacts and new investment opportunities with an experienced group of syndicators.

Final Thoughts and Looking to the Future

Any basic real estate market study will tell you that it is cyclical. Downturns follow periods of growth before going back up again. It’s no use trying to time the market, and even the most experienced investors can get it wrong from time to time. What matters more is that you spread your investments out through diversification to minimize risk and maximize returns. You can start by looking at your current investments and evaluating any weak spots or opportunities for growth.

It’s not easy to get out of your comfort zone and start dabbling in areas of the market you’ve never dealt with before. But that’s what separates the most successful investors from the average ones.