3 Important factors of Diversification in Passive Real Estate Investing

3 Important factors of Diversification in Passive Real Estate Investing

After interviewing many successful commercial passive real estate investors and investing in more than 50 deals myself.

I collected the very important factors to take into consideration when approaching diversification in passive real estate investing – geography, asset-class, and syndicators.

Geography Diversification

Some investors like to invest locally, where they live which can be defined as a location that is within an hour or two-hour drive. Others will invest out-of- state, but all in one sub-market. I wanted to invest locally, since I live in Silicon Valley, one of the most expensive markets in the US if not the world, the numbers did not make sense. The price to rent ratio is out whack here, its almost impossible to find cash flowing property locally, especially large commercial assets. There are thousands of different ways to invest and most of them are effective. However, there is a problem with having all of your properties concentrated in just one geographic location: you are much more susceptible to economic, weather, and other geographically related risks.

If there is a major earthquake, for example, and it happens often here in California where I currently live and you own 10 properties within 3 miles of each other that are all destroyed, you are in trouble. I know this is a crazy example, but it is still a risk.

Florida is hit by hurricanes often, which most likely had a major effect on some real estate. While it might be okay to own real estate in Florida, if you were heavily invested in Miami only and one hurricane wiped out half of your properties, again, you are in big trouble.

Another weather related example – some people invest in six different funds with some very large mobile home park operators, with one being the 5th largest in the world. One investor I know shared a story about why they have no issue with investing in areas that have tornadoes, but they avoid hurricane areas. The reasoning was that when a hurricane hits, it typically wipes out a massive territory. As a result, the different governmental agencies and insurance companies are too overwhelmed and can’t handle it, so it takes forever to repair the damage. But for tornadoes, a more isolated area is affected, so FEMA will come in immediately and help. Isolated areas are much more manageable. In this specific situation, these mobile home operators had all of their homes that were damaged or destroyed by a tornado replaced for free. The lesson here is that tornadoes are manageable and hurricanes are unmanageable.

Besides weather related risks, another reason to diversify across different geographical areas is that each has its own unique economies and as a result, it’s own unique challenges. If you are invested in a city or area that relies heavily on a specific employer and they decide to relocate their offices across the country, you are again in big trouble.

There are countless other examples, so all in all, it is important to spread your investments out across different geographical areas.

Asset-Class Diversification

It is also important to diversify across different asset classes, both from an asset-type and tenant perspective. For example, many other real estate investors including me won’t invest in apartments unless they are 100 units or more. For a 100 unit building, when one tenant leaves his vacancy rates increases by 1%. On the other hand, if you invest in a triplex and one tenant leaves, your vacancy rate increases by 33%!

Diversifying across asset-types is key because certain types perform better in a growing economy while others perform better, or are at least more manageable, during a recession. For example, office and retail don’t perform as well during a good economy, but can go through a recession relatively well. Specifically, retail with anchor tenants – big grocery stores like Walmart or Target. Mobile home and self-storage – can perform even better during when the economy is slowing down. During the last recession, self-storage vacancy only increased by 1%. This is probably due to the increase in demand that came from homeowners who were foreclosed on and needed a place to store all their personal items.

In the long-term, you want to be as diversified as possible. In doing so, whether we are in a good economy or a bad economy, the cash flow is still going to come in. This is especially important if, like many investors who want to be passive, you are dependent on cash flow to live off of.

We do not recommend that you invest in every asset class. For example, some people don’t invest in hotels or industrial space. On average, these asset classes tend to do really well in an upturn or positive economy. However, they tend to have really quick revenue reductions during a downturn. Some investors don’t want to be exposed to that volatility.

Therefore, it is important that you diversify as much as possible, but make sure that you are comfortable and knowledgeable in all the asset classes you select.

Syndicator Diversification

Whenever you invest passively, you are trading control for diversification. You are giving someone else control of the day-to-day operations and you are probably investing with multiple different investors, so your control is minimized. Therefore, if you are going to give up control, you better trade it for diversification. Experienced real estate investors find that there is always a 1% risk with operators, due to the possibility of mismanagement, fraud, a Ponzi Scheme, etc. You are increasing your risk inherently by being a passive investor. To mitigate that risk, diversify across operators. Don’t have too many eggs in one basket.

Everyone has their own take on the maximum exposure an investor should have in terms of number of operators. The common number that we see is that people don’t like to be exposed to an operator with more than 10% of their total capital. The same applies to geography and asset-classes too.

It is also important to keep in mind that proper diversification takes a long time, but it is the best way to reduce risk. The more diversified, the better you are in the short and long run. We recommend that you shouldn’t invest more than 5% of your capital into each opportunity. This means that your goal should be to diversify across at least 10-20 different opportunities. At that point, you can determine how many operators you are comfortable with – 1, 3, 5 or more, depending on the person. Obviously,it is very subjective and depends on what you are comfortable with.

Conclusion

Diversification in real estate investing is a must to ensure long-term success and reduce risk. We recommend to diversify your investments by keeping three essential factors in mind:

  1. Geography
  2. Asset-class
  3. Operators

We believe your ultimate investment goal should work towards investing no more than 5% of your overall capital into a single opportunity and to expose no more than 10% of your capital to a single geography, asset-class, or with a single operator.

Happy Investing!

More about the author: Alex Kholodenko

Alex is a Managing Partner at Wealthy Mind Investments.