9 Ways to Diversify Your Real Estate Portfolio
"You should have a strategic asset allocation mix that assumes that you don't know what the future is going to hold."
So you’ve conquered your local real estate market. You’ve got 6 or 8 rentals, each earning cash flow. Congratulations! Now… what if a natural disaster decimates the area, or if the economy suffers a major setback? Uh oh…. you need 9 Ways to Diversify Your Real Estate Portfolio!
If you were heavily invested in New Orleans before Hurricane Katrina, Detroit Michigan before automotive industry layoffs, or almost ANY market prior to the Great Recession, you understand the risk.
Investing in real estate is a time-tested strategy and one of the BEST ways to diversify away from the stock and mutual fund investments that most Americans already have. Yet how can you diversify your real estate investments? Without doing this, you could be vulnerable to setbacks and losses. So let’s look at some options to make your real estate portfolio “bulletproof.”
To truly diversify your real estate portfolio, consider expanding into different types of properties that can withstand market fluctuations. This is crucial to effectively diversify your real estate portfolio.
Locations, Locations, Locations
A fantastic location (singular) is great, yet if circumstances or the local economy changes the desirability of a location, you’re better off with having multiple properties in multiple locations. Consider different cities, different areas of the country, even (perhaps) international real estate—of course with care, caution, and reliable professional advice!
Another wise move is to diversify the types of economies that fuel your real estate investments, such as working class neighborhood homes, commercial properties such as office spaces, and resort condos popular with upscale retirees and vacationers.
Would you prefer to be a “hands off” investor and skip all the location scouting, negotiation, tenant management and plumbing problems? You can! Bridge loans and real estate equity investing are the simplest way to expand the types of properties you invest in. Even if you enjoy investing locally, first deeds of trust or bridge loan funds that invest in properties elsewhere can give your investment strategy stability.
Besides diversifying the location of your holdings, investing in different of real-estate-based investments is also very important. See which of the following types of investments might be a good fit for diversifying your real estate portfolio.
9 Ways to Diversify Your Real Estate Portfolio
There may be endless options, but some of the more popular types of real estate investments include:
1. Rental homes
When considering rental homes, always think about how they fit into your goal to diversify your real estate portfolio.
A great “bread and butter” investment, you can get started by either renting out a home you move out of when you purchase a new one, or purchasing a home specifically for the purpose of renting. Either way, you’ll want to do your math! Perhaps the biggest mistake people make with real estate is counting on appreciation while paying too little attention to cash flow. We think that cash flow should be the cake, and appreciation—if you get it—makes for wonderful “icing on the cake.” (We use the Truth Concepts Real Estate Analysis Calculator to calculate returns.)
Done wisely, buy-and-hold rental homes can allow you to take advantage of long-term cash flow as well as potential appreciation and tax advantages. You can keep rental homes for years or even decades until market conditions are excellent for selling. Meanwhile, your tenants pay the mortgage and other costs.
2. Commercial Real Estate
Investing in commercial real estate can also provide an opportunity to diversify your real estate portfolio and tap into different revenue streams.
This is similar to rental homes or residential real estate that you own and rent them out, except these properties are commercial in nature, such as office buildings, warehouses, or storefronts.
Commercial real estate can be an excellent investment, although you might expect higher start-up costs. Commercial markets can also be more fickle than residential markets, so be aware of this. While residential markets tend to be fairly stable, it is not unusual for office buildings to sit empty during a downturn, or for a “hot neighborhood” to turn sluggish when the next hot neighborhood surfaces.
3. Commercial Bridge Loans
You may be familiar with residential bridge loans as a temporary financing tool which allows a homeowner buying their next home to access the equity in their existing home until they can sell it. With a commercial bridge loan, the temporary financing is done on a commercial property, such as a hotel, office or apartment building. A “bridge loan” puts financing in place while a property is improved or rehabbed, or while an income history is established that can allow the owner to secure permanent financing at more favorable terms.
4. Apartment Buildings
Apartment buildings are a solid choice when looking to diversify your real estate portfolio, offering both cash flow and appreciation potential.
Perhaps the “gold standard” of real estate investments, multi-family apartment buildings typically produce higher returns than rental homes. A well-managed apartment building in a desirable area can generate low double-digit returns consistently, plus nice tax advantages and the potential for future appreciation!
The downside of apartment buildings is that it’s not a beginner’s game. There can be a significant financial investment, plus managerial experience required to do it well. Done poorly, you can end up losing money and/or dealing with nightmare tenants
5. "Flipping" Homes
Flipping homes is another strategy, but consider how it fits into your broader plan to diversify your real estate portfolio.
In spite of the popularity of cable TV shows that make this look easy, it’s not! It’s trickier and less profitable than you think. Quality contractors aren’t cheap, and if you do the work yourself, you have to factor in the value of your time and effort. There can be big risks involved, as a dip in the market can wipe out your profits, And keep in mind, your money has a cost, which is ignored by misleading “reality show math.” TV shows fail to factor in interest costs, lending costs, or closing costs such as title, escrow, so consider these shows as entertainment, not factual representations.
6. Lease-to-Own Homes
Lease-to-own homes can be a unique way to diversify your real estate portfolio, catering to a specific market segment.
Investing in lease-to-own single-family homes can be a successful strategy in markets such as those with depressed housing prices. According to professional real estate investor Jimmy Vreeland, lease-to-own strategies offer unique advantages to investors willing to learn how to do it well.
Lease-to-own strategies provide a mix of both short-term and longer-term profits. And lease-to-own sellers/landlords experience decreased management burdens because tenants are hopeful buyers willing to care for their future property and assume maintenance tasks themselves. This reduces risk and costs for both the sellers and their private lenders.
7. REITs
REITs are very popular with investors right now because of recent favorable returns and the ease of investment. Most function much like a mutual fund or a private equity fund and offer a “hands off” way to invest in real estate. However, REITs can offer similar downsides as mutual funds, performing poorly in a down economy. According to a New York Times article, during the financial crisis, “Just as stocks fell fast and furiously, so, too, did most REIT shares.” In 2008 alone, commercial property REITs (the majority) dropped 49% in value, while mortgage REITs lost 42%. Thus, we can’t recommend REITs as a diversification strategy.
8. Land
Investing in land should be considered carefully when you aim to diversify your real estate portfolio.
While land can have its place in a portfolio, it can present a challenge for investors. Unless the land is being leased — perhaps for farming, camping, or for oil and gas exploration and development — land does not typically produce cash flow. So purchasing land is usually speculative in nature. People buy land, hoping or assuming the price will rise. Meanwhile, they’ve got property taxes to pay.
We prefer to put assets to work earning cash flow, so we would recommend putting your cash into land leases rather than raw land you hope will be more valuable in the future.
9. Part-time Rentals
Part-time rentals can be an excellent way to diversify your real estate portfolio while also providing income during your ownership.
Like to travel? Fancy a vacation home? Savvy investors look for second homes that can earn money when they’re not there. This works especially well for properties with year-round demand, such as New York City condos, resort homes in Hawaii, or beachfront properties in Southern California or Florida. You can hire a management company to manage rentals, or manage them yourself using Airbnb or VRBO.
Of course, while you’re away… you can also rent our your “first” home! We know a coach with a travel bug who rents two rooms on Airbnb when at home, and when traveling for extended periods, she rents out her entire home (to a single party, requiring no day-to-day management). In this way, she has all but eliminated her mortgage payment year-round, giving herself increased income and freedom while building equity in a six-figure asset that also provides a “home base.”
Is it Time to Diversify Your Real Estate Portfolio?
Ultimately, a safe bet is to diversify your real estate portfolio into multiple types of real estate investments. That way, all your eggs aren’t in one basket, and you don’t lose everything in one market downturn.
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