How to Diversify Your Real Estate Portfolio

Why diversify your real estate portfolio?

This blog walks through the importance of diversifying your real estate portfolio.

Most new real estate investors are attracted to high yields and assume that finding properties with high cap rates the most important factor when it comes to investing.

This might be true when it comes to investing in stocks or crypto, but it couldn't be further from the truth when it comes to real estate investing.

When investing in real estate, you want to make sure not to put all of your eggs in one basket and invest in just one asset class or market.

A few examples of putting all of your eggs in one basket include:

• Only investing in single family homes
• Only investing in one market
• Only investing in short term rentals (Airbnb)

When investing in real estate, or any asset class for that matter, you want to make sure and diversify and hedge your risk.

What if the largest employer in the one market you invest in shuts down? Or new laws are put into place making it more difficult to rent your property on Airbnb?

These situations are possible, and if they happen, you want to make sure that you've diversified your portfolio so you don't take as big of a financial hit.

Diversification allows you to distribute your money across a variety of investment strategies. This not only protects your portfolio from sharp losses, but it also expands your opportunity to profit from a number of sources.

Why real estate diversification is important 

Diversifying your real estate portfolio is a risk management strategy.

Having a diverse portfolio of real estate can help 

• To reduce overall risk
• Reduce losses in down markets while also conserving wealth during bull markets
• Reduces portfolio volatility by allowing different assets to rise and fall at different times
• Allows for more consistent portfolio returns

Different ways to diversify your real estate portfolio

Low cap rate vs. high cap rate properties

When it comes to real estate investing, a lot of numbers are thrown around.

Cash flow, return on investment, net income, and cap rate are all important factors to consider.

It's difficult to make sense of all the figures, but if you only focus on one, it should be the cap rate. 

Many investors prefer to purchase properties with lower cap rates (lower yield) compared to properties with higher cap rates (higher yield).

Although it may appear backwards and not make sense, there are numerous reasons why investors behave this way.

Properties with lower cap rates tend to be less risky.

A few reasons why below:

• Lower cap rate properties are often located in nicer areas
• They typically have higher quality tenants
• These properties tend to be newer builds, so there's less of a risk of repair

Asset type diversification 

One of the things that make real estate investing so distinctive is the range of asset types available.

The different real estate asset types include:

• Residential (1-5 units)
• Multifamily
• Office
• Industrial
• Retail
• Self-storage
• Mobile homes

By investing in multiple asset types, you can protect yourself from larger macroeconomic shifts.

This includes the current shift in the retail space with the rise of e-commerce as well as the transition away from physical office spaces in favor of remote work.

Had you only been invested in office buildings pre-COVID, you would have been hit hard.

Diversification is key.

Location based diversification 

Real estate is hyperlocal, meaning that while one city can be thriving, another might be slowing down.

By diversifying across several geographies, you can 

• Profit from the ups and downs of multiple markets 
• Hedge your investments against a significant market correction 

If all of your real estate holdings are concentrated in one market, and that market experiences a downturn, your entire portfolio could be jeopardized. 

If you have one investment in Orlando, another in Dallas, another in Los Angeles, and so on, the overall impact on your portfolio would be much smaller.

Look for markets with substantial job growth, population growth, and job diversity when diversifying across geographies.

Strategy and hold time diversification

Changing up your investment strategy and holding duration is another great way to diversify.

While one rental property may be a good buy-and-hold investment, another may be better suited to the buy, rehab, rent, refinance, and repeat (BRRRR) method.

Even within a single geographical market, diversifying by investment technique is a useful method to protect your portfolio.

In terms of hold time––due to market conditions or your investment strategy for particular properties, you can have a shorter horizon on certain properties and expect to sell in a year or two.

Other properties may have a longer time horizon and be held for many years or even passed down to your children.

Active vs. passive investing diversification 

Finally, incorporating a mix of active rental properties and passive real estate syndications (group investments) into your portfolio can help improve diversification further.

Passive syndication investments are typically larger commercial assets like apartment buildings, whereas rental investments are typically smaller residential properties. 

Furthermore, with your own rental properties, you typically manage the asset yourself. However with a syndication, you benefit from expert syndicators' experience and track record.

Investing in different tier markets

When diversifying your real estate portfolio, it's important to invest across different tiered markets.

The different tiers of markets include:

• Primary markets
• Secondary markets
• Tertiary markets

Primary markets

Primary real estate markets are best known for being the nation’s economic leaders.

They have large population bases and provide a substantial contribution to the GDP of the U.S.

Primary markets include cities like:

• Los Angeles, CA
• New York, NY
• Seattle, WA
• San Francisco, CA

The real estate in primary markets is significantly more expensive than anywhere else in the US, and also tends to have much lower cap rates.

The cap rate for a single family home in Los Angeles might be 3% whereas the same property in Oklahoma City might be 9%.

Although the cap rate is lower, properties in primary, tier 1 markets tend to appreciate significantly more than properties in secondary and tertiary markets.

Secondary markets

A good way to think of secondary markets is U.S. cities that aren't among the most populous or dense areas, but still have the majority of the amenities associated with larger cities.

Key characteristics of secondary real estate markets include strong population and job growth, large rent price increases, with home prices that are still relatively affordable.

One commonly used definition is that a secondary market has a population of up to 500,000.

Secondary markets include cities like:

• Charleston, SC
• Nashville, TN
• Houston, TX
• Cleveland, OH

Secondary markets have higher cap rates than primary markets, but tend to incur less appreciation over time.

Generally, secondary markets are less volatile in times of recession. This makes secondary markets attractive to long-term investors.

Tertiary markets

A tertiary real estate market generally has a population of less than 100,000 people.

Living costs are typically less expensive than in primary and secondary markets.

While they may not have the same amenities, tertiary markets often see a slow but steady stream of inbound migration and steady employment growth.

Tertiary markets include cities like:

• Boise, ID
• Sacramento, CA
• Little Rock, AR
• Tucson, AZ

Tertiary real estate markets oftentimes have home prices and rents that are more affordable than larger secondary and primary markets.

For example, during the pandemic, tertiary markets such as Greenville, Las Vegas, and Tallahassee saw unprecedented population growth as residents migrated from larger urban areas.

Closing thoughts

Like any investment, it's important to make sure you are diversifying your real estate portfolio.

You never know what the future holds, and you don't want to be the person that heavily invested in office buildings right before COVID hit, or the person that invested heavily in retail right before Amazon started to take over the world.

Nothing is a sure thing. Because of this, it's always important to diversify even if you think you've found the perfect investment vehicle.