Diversifying Your Real Estate Investments: How Important Is It?
Any experienced investor knows that diversifying real estate investments is key to long-term success.
Many real estate investors get started with single-family homes (SFH) because the market is more accessible than commercial real estate or multi-family properties. This is a natural first step, but it shouldn’t be the last.
Expanding your portfolio to include different asset types lowers your overall risk.
Not only should you buy different assets, but also spread those investments out across different markets. Any number of factors could wipe out home or real estate values in an area -- and you want to guard against that volatility as much as you possibly can.
However, diversifying beyond single-family homes will not guarantee profits -- nor will it fully ensure you won’t have losses. But for high-net-worth investors, it’s definitely the best route to take.
In this article, we explain why.
The Benefits of Investing in Single-Family Homes (SFHs)
First, there are a variety of benefits to investing in single-family homes versus multi-family homes and other properties:
- Lower cost
- Easy financing
- Easy to sell (even during the current COVID-19 pandemic, demand for single family homes is rising)
- Higher appreciation
- Better tenants (Many SFH renters are families who want to stay in one place and take better care of the property)
All in all, these points fall under the same general category: Easier accessibility. It’s simply easier to get started with a SFH than any other real estate asset type. That’s why so many real estate investors begin with SFHs.
As with any investing approach, it’s smart to start small and work your way to bigger properties. Buying one SFH is less daunting for new real estate investors than buying a multi-family property. After all, taking care of one tenant (or one family) is much easier than taking care of two or more.
Most Royal Legal Solutions clients initially invest in SFHs and eventually branch out into industrial real estate, multi-family housing, retail, medical, and self-storage. Why? Because they begin to realize that all of their eggs shouldn’t be in one basket.
Different assets have different risk factors -- and sometimes, in real estate, different properties are complementary. If the demand for SFHs collapses and property values plummet across the nation, then the slack has to be picked up by apartment and multi-family properties (because people have to live somewhere, after all).
In addition to diversifying across asset types, it’s just as important to diversify across markets.
Locations, Locations, Locations: Don’t Get Tied Down in One Area
There are advantages to having your investment property near where you live. If anything goes wrong—say, your tenant gets locked out of the building or the power goes out—you can be there to offer hands-on assistance.
But spreading out your investments across different real estate markets is also important.
Concentrating your holdings in a particular city or area makes your entire portfolio subject to the fluctuations of local supply and demand. Even in the best areas, there are a number of factors that could seriously hurt real estate market values:
- A natural disaster (hurricane, flood, earthquake, etc) destroys homes and buildings. (Even if you have insurance, entire communities don’t easily bounce back).
- A major business/employer shuts down or relocates.
- Crime waves hit the area.
- The school system takes a nose-dive.
- Mismanagement of local government funds leads to major infrastructure issues (poorly maintained roads, bridges, etc).
Even if you own a variety of real estate asset types in a single location, you still aren’t as diversified as you could be. If you lived and invested in New Orleans in 2005, it didn’t matter if you owned a single-family home, a condo, a four-plex, a self-storage facility, and a corner convenience store—Hurricane Katrina would’ve dealt a massive blow to your portfolio (unless you were amply insured and looking to cash out).
Experienced real estate investors avoid over-concentrating in one particular asset class or location. If, instead, your assets were spread out across the entire continental United States, your portfolio wouldn’t have been affected quite as much.
High-net-worth investors know that a real estate portfolio with a range of asset types, spread out across different locations, puts them in a better position to withstand economic downturns and events like the COVID-19 pandemic and natural disasters.
Why Different Asset Types are Key to Diversifying Your Investment Portfolio
Dwight Kay, founder of Kay Properties and Investments, a national 1031 exchange investment firm, outlined an example of how a hypothetical investor can diversify a $500,000 investment portfolio across commercial and multifamily real estate with the potential for income and appreciation. The funds would be equally spread among these assets:
- An industrial distribution facility
- A dialysis center
- A multifamily apartment community with 300 units in the Southeast
- A self-storage facility in the Midwest
- A debt-free multifamily property in Texas
Kay says this hypothetical investor “has diversified her portfolio by both asset type and geography.”
The hypothetical investor has also avoided highly cyclical and volatile markets, like senior housing and buildings involved in oil and gas production.
Conclusion: Diversifying Your Real Estate Investments
When it comes to real estate investing, it’s easiest to get started with a single-family home. The cost is lower, the financing options are plentiful, and the tenants typically care more about general upkeep than a multi-family or apartment building. Naturally, that’s where many investors start.
However, as time goes on, it’s smart to diversify across different asset types. That includes:
- Multi-family buildings
- Self-storage facilities
- Distribution centers
- Convenience stores
- Medical centers
Not only is it a good idea to invest in different asset types, it’s also a good idea to spread those investments out across different markets. A number of factors could wipe out real estate values in any given market, and they aren’t always within your control (nor are all of them easily insured against).
Avoid cyclical, highly volatile asset classes, including senior housing and long-term senior care facilities, hotels, and real estate used in the production of oil and gas.
Focus on diversifying your portfolio by buying different assets in different markets. Don’t get too caught up in solely buyings single-family homes in one market. Remember: the demand could disappear in just a few short years.