Diversification is investing in multiple businesses across different sectors to achieve the same level of return. However, diversification is equally important, though it is a bit different when it is related to investing in real estate.
For example, investing in the S&P 500 Index fund is an excellent way to attain stock diversity as it invests in 500 companies that make up the S&P 500 Index, comprising a broad range of companies spread across 11 segments. A fund with a diversified portfolio, like the S&P 500 Index fund, allows consumers to get returns that align with that of the S&P 500 without purchasing shares of every 500 companies.
An S&P 500 Index fund perfectly shows how diversification in stocks is adequate. Through spreading risk across many industries and businesses, potential losses from certain stocks can easily be offset by the gains of other stocks. This is a balance that allows investors to keep an amount of profit.
But a diversified fund, such as the S&P 500 Index fund, also exposes the flaw in stock diversification.
Why a Diversified Real Estate Portfolio Is Better Than a Diversified Stock Portfolio
The function of diversification in passive commercial real estate (CRE) investments differs from the one it has with stocks since the goal is different. The purpose of investing in CRE, which is passive, is to increase wealth and not simply maintain a certain amount of return.
Consider CRE investments made passively as a part of an asset-building machine fed by the cash flow generated by an investment portfolio. When you supply your device in cash, it builds the money with appreciation and investment reinvestment.
Contrary to stocks, which aren’t protected by diversification from a financial crash, diversification in the passive CRE asset class has proven to protect investors from downturns, securing your wealth creation machine. Since investors can diversify CRE assets across geographical markets and kinds of property, asset classes, and investment strategies, the proper combination of properties will guarantee an uninterrupted cash flow.
If you have the right assets in the right places, the income could dip in certain investments but will not stop accelerating. People do not need homes or businesses (e.g., offices, offices, warehouses, etc.) overnight. Because CRE assets aren’t liquid, they cannot be sold during a downturn like stocks, reducing their value.
The 2008 financial crisis and the most recent pandemic-related crisis have shown the world that recessions do not similarly affect markets and asset classes. Specific markets have more resilience than others. The trick is to ensure you don’t put everything in the same basket.
Diversification Options: Public vs. Private
Passive CRE investments can be found in both private and public markets. How do they compare one another in terms of diversification and ability to endure market declines? REITs (real estate investment trusts) are the primary investment alternative in the public market. In the private market, real estate syndications, as well as private equity, are two options.
Pros REITs are traded on the stock exchange. Investors can purchase just one share of REIT stock. In theory, investors can buy multiple REITs with no huge investment costs to broaden their investment portfolios.
Cons: On the other aspect, trading in the public market can create volatility due to being correlated to the market. If there is a crash, REITs won’t be protected. In the event of a recession, management always receives the first payment.
Pros: Real estate syndications are ubiquitous. The investment options are available in all states (and even overseas) in all property and asset classes. The possibility for investors to diversify their portfolios through syndications is available. Furthermore, the investors are first due to the waterfall compensation models common to property syndications. Even when profits suffer, the investors are usually the first to be rewarded with payments.
Cons If it is in the wrong hands of management, syndications are dangerous.
Pros: Private equity firms that invest in real estate invest in private companies that invest in real estate, not real estate properties. Investing in a PE firm with a diverse portfolio of private firms in different asset classes and markets eliminates the requirement that investors invest in several firms to diversify.
Cons The cost of admission into PE firms is generally more expensive than syndications, often starting at $250,000 and up.
Investments are a lot more confined to the things they know. This means they invest in one class of assets in their backyard. This leaves them no opportunities to diversify and increase their income stream across various asset classes and geographical markets.
How can you begin? You must be active if you want to diversify your CRE portfolio across multiple types of markets, asset classes, and property types. Find opportunities by syndications and PE businesses that can assist you in achieving this goal.
Connect with agents and brokers with connections to new markets that you might find interesting. To establish these connections, leverage social media (LinkedIn, Facebook, etc.). There is a good chance that agents and brokers are familiar with active syndications and PE firms that are active in their respective markets. Additionally, thanks to eased advertising regulations applicable to private exempt offerings, passive CRE investment opportunities are now available online.
To achieve true diversification that will preserve income and insulate against downturns and volatility, look beyond your local market and core competency. Find experienced managers and syndicators who’ve been through the ring and are adept at navigating their way through the complexities of a crisis. Selecting and screening competent managers is crucial to reaching your goals of diversification.