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How To Manage Real Estate Investment Risk With Diversification

Realized
·6 min read

Measuring risk in real estate is difficult for several reasons. First, because there is not a widely accepted risk measurement unit with real estate (unlike stocks and bonds that have standardized metrics), it’s difficult to compare different investment options.

Another reason measuring risk is difficult is because macroeconomic events have different impacts on real estate investments depending on the property type and location of the investment.

Despite this difficulty, there are actionable steps real estate investors can take to help manage their overall risk.

Using Correlation and Diversification

The heart of risk management is correlation, or how things move directly or indirectly relative to each other. Choosing investment opportunities that are not directly correlated to each other, whether in property type or geography, can diversify the risk exposures in an investor’s portfolio, thereby potentially reducing overall investment risk.

In the context of your real estate investments, it is easy to imagine what could happen if things don’t go as planned with all of your investments concentrated on one real estate market or one real estate property type, which is why we believe it’s important to diversify the investments in your portfolio.

This concept was first introduced to the investment world by Nobel Prize winner Harry Markowitz in the 1950s under the Modern Portfolio Theory. He successfully demonstrated how a diversified investment portfolio consisting of investments with very low correlations to each other would have lower volatility than that of its individual components (investments). The main purpose of diversification is not to eliminate risk but manage (reduce) it. It’s a strategy that can also be applied by real estate investors.

Take, for example, the impacts of the Covid-19 pandemic. On the surface, some might say the pandemic affected all kinds of real estate, but when looking more closely at how it affected different property types and geographies, the impacts were not uniform.

The Different Effects of Macroeconomic Events

When evaluating commercial real estate options like office buildings, apartments, retail centers, warehouse facilities, medical offices, data centers, cell towers, and hotels, each of these investment types was affected differently by the current health and economic crisis. For example, hotel occupancy has decreased since the beginning of the pandemic as more people stayed at home and restricted their travel, but cell towers and data centers saw an increased need as more people began to work from home.

Retail centers may have been adversely affected as online sales became more popular during the lockdowns around the country, but demand for warehouse distribution centers, which was already strong pre-pandemic, surged as online retailers like Amazon continue to need and demand space to store and ship inventory.

While no one is able to predict when such a massive macroeconomic event will happen, a diversified real estate portfolio can provide better balance for investors. If an investor’s portfolio had different property types represented, even if some of your investments suffered a hit during the pandemic (hotels), some better-performing assets (distribution centers) could provide enough return to offset those losses – or hopefully offer a positive return.

How to Find Diversity in Real Estate

Diversification within a sector may initially sound like something not easy to achieve. Investment options can be expensive, and sometimes difficult to access. Fortunately, real estate investors can diversify by property type, geography, and strategy, and different investment options are making it easier for investors to access these institutional property types.

Historically speaking, it was not always easy for real estate investors. Wealthy investors certainly have the means to acquire real estate directly and can diversify by geography and asset type. While the ability to invest directly in large commercial property options in different markets might be appealing, investors will be on the hook for everything, including managing, financing, and leasing their individual property.

Many people, for obvious reasons, don’t want to deal with all the headaches of direct property ownership or don’t have the funds necessary to invest in institutional-grade properties on their own. For investors looking for alternatives, there are plenty of options in private and public real estate markets.

Some of the widely used structures include real estate funds (typically in the form of an LLC or Limited Partnership), Delaware Statutory Trusts (DSTs), or Real Estate Investment Trusts (REITs). Some real estate can be accessed in public markets through publicly-traded REITs, which trade on exchanges similar to stocks.

REITs

Publicly-traded REITs have many potential advantages, including providing exposure to nearly every major property type, daily liquidity, and quarterly dividends. However, the exchange-traded benefits of a publicly-traded REIT can also be a potential drawback, exposing investors to daily pricing volatility. Additionally, publicly-traded REITs may be more correlated to the stock market than their private real estate counterparts.

This reduces the lack of correlation benefit between real estate investments and public equities (stocks). Statistically speaking, private real estate options like DSTs or private funds, have a lower correlation to the broader stock market, resulting in a potentially greater diversification benefit. Even so, investors should consider the (lack of) correlation benefits compared to investment liquidity.

LLCs or Limited Partnerships

In private markets, investors can form an LLC or limited partnership to invest in real estate funds that are professionally managed. This structure will allow you to be part of a bigger pool of capital to acquire income-producing properties, providing access to properties investors likely cannot access on their own.

Most of the time, your status will be a limited partner in this type of structure, while the sponsor or general partner will be managing the fund. This allows investors the chance to own investment properties without the headache of direct property ownership.

DSTs

DSTs are another private real estate investment vehicle that offers investors fractional ownership of commercial real estate. Similar to real estate funds, a DST investor’s equity is pooled and used to invest in a variety of different asset types across the nation. By investing in a DST, you are able to diversify your asset type according to geography and property type, reducing correlation and managing overall risk.

Additionally, DSTs may have certain tax advantages, such as the ability to conduct 1031 exchanges into and out of the investment. While this investment structure helps with risk management, DSTs are considered illiquid, which is something to consider when evaluating investment goals.

Risk can seem like a big, complex concept to understand when it comes to real estate investment options. However, it can be managed. When performing research and due diligence on the investment options you have available, break down the options according to property type, geography, and correlation between assets to help determine what the best options are for you and your goals.

Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation. There is no guarantee that companies that can issue dividends will declare, continue to pay, or increase dividends.

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