Diversification can be defined as investors putting their money in multiple companies across multiple industries to maintain a certain level of return. But diversification is equally as important—albeit somewhat different—when it comes to real estate investing.
For example, investing in an S&P 500 Index fund is one of achieving stock diversity since it invests in the 500 stocks that comprise the S&P 500 Index, which includes a cross-section of companies across 11 segments. A diversified fund like an S&P 500 Index fund allows retail investors to achieve returns that track the S&P 500 without having to buy shares of all 500 companies themselves.
An S&P 500 Index fund perfectly illustrates how stock diversification works. By spreading risk across multiple companies and industries, expected losses from some stocks can be offset with gains from others. It’s a balancing act that allows investors to maintain a certain level of return.
However, a diversified fund, like an S&P 500 Index fund, also reveals the flaw with stock diversification. What if the whole market sinks? Diversification won’t spare you from a 50.9% drop in the Dow like in 2008.
The role of diversification in passive commercial real estate (CRE) investments is different than the role it plays with stocks because the end-game is different. The objective of investing in passive CRE investments is to compound wealth—not to merely maintain a certain level of return.
Think of passive CRE investments as part of a wealth-building machine that feeds off the cash flow from a portfolio of investments. As you feed the machine with cash, it compounds that cash through appreciation and reinvestment.
Unlike with stocks where diversification won’t save you from a crash, diversification in the passive CRE asset class has proven to insulate investors from downturns, protecting their wealth-building machine. Because investors can diversify CRE assets across geographic markets, asset classes, property types, and investment strategies, the right mix of properties will ensure uninterrupted cash flow.
With the right assets in the right markets, income may dip with some assets but won’t come to a screeching halt. This is because people don’t stop needing housing and businesses (e.g., offices, warehouses, etc.) overnight. And because CRE assets are illiquid, owners don’t unload them in a crisis like with stocks, driving down their values.
The financial crisis of 2008 and the latest pandemic-induced crisis have taught us that not all markets or assets are equally affected by downturns. Some are more resilient than others. The key is to not have all your eggs in one basket.
Passive CRE investments are available in both the public and private markets. But how do they stack up against each other in terms of diversification and the ability to withstand market downturns? In the public markets, REITs (real estate investment trusts) are the principal investment option. In the private markets, real estate syndications and private equity are two alternatives.
Pros: Because REITs are publicly traded, investors can buy as little as one share of individual REIT stocks. Theoretically, investors could buy multiple REITs without huge capital outlays to diversify their portfolios.
Cons: On the flip side of the coin, being traded publicly can cause volatility by correlating to the entire market. In a crash, REITs will not be insulated. Moreover, in a downturn, management always gets paid first.
Pros: Real estate syndications are ubiquitous. Investments are available across every state (and even offshore) and across all asset classes and property types. The opportunity for investors to diversify through syndications is readily accessible. Additionally, because of waterfall compensation structures common in real estate syndications, investors come first. In a downturn, even if profits are squeezed, investors will typically be the first ones to receive distributions.
Cons: In the hands of the wrong management, syndications can be risky.
Pros: Real estate private equity firms invest in other private companies that invest in real estate—not in properties. The benefit of investing in the right PE firm with a diversified portfolio of private companies in multiple markets and asset classes is that this reduces the need for investors to invest in multiple companies themselves to diversify.
Cons: Cost of entry into PE firms is typically higher than with syndications, sometimes starting at $250,000 or more.
Investors tend to stick to what they know. That means investing in one asset class in their backyard. This deprives them of opportunities to expand and diversify their income stream across multiple asset classes and geographic markets.
How do you get started? If your goal is to diversify your passive CRE investments across multiple markets, asset classes, and property types, be proactive. Seek out those private opportunities through syndications and PE firms to help you achieve this goal.
Make connections with brokers and agents who are connected to new markets you may be interested in. Leverage social media (LinkedIn, Facebook, BiggerPockets, etc.) to make these connections. Chances are these brokers and agents are familiar with the active syndications and PE firms in their markets. Besides, with relaxed advertising rules applicable to certain private exempt offerings, passive CRE investment opportunities can now be found through a web search.
To achieve true diversification—diversification that will preserve income and insulate against downturns and volatility—look beyond your local market and core competency. Seek out seasoned syndicators and managers who have been around the block and know how to navigate their way around a crisis. Screening and selecting competent management will be key to achieving your diversification goals.
What are your strategies for diversifying your real estate investments?