Diversifying a portfolio by investing in real estate can help to manage risk and potentially improve long-term returns. It can also boost income and your portfolio’s capital appreciation. Real estate investments can be diversified by investing in different types of real estate and different geographic regions and also by balancing riskier real estate investments against less-risky ones. For help building a diversified real estate portfolio, consider working with a financial advisor.
Diversifying a portfolio helps to reduce risk and improve returns. One way it does this is by spreading investment dollars over several asset classes. In addition to real estate, stocks and fixed-income securities, asset classes include cash, commodities, art and collectibles.
A diversified portfolio includes investments in multiple asset classes. Investing in real estate, for example, can improve the diversification of a portfolio that is otherwise invested in stocks and bonds. Real estate is an especially effective asset for diversification because it is not tightly correlated to the securities markets. When stocks and bonds are down, that is, real estate may be up and vice versa. In this way, diversification helps investors minimize losses due to broad market trends.
In addition to diversifying across asset classes, investors also often seek to diversify within asset classes. For example, the equities portion of a portfolio may be divided into investments in large-capitalization domestic stocks, small-capitalization domestic stocks, international stocks, emerging market stocks and so on. This further diversification amplifies the risk-reducing effects of diversification.
Real Estate Diversification
Diversifying real estate investments can take several forms. One way is to invest in different types of real estate. For example, investors may put money into both residential and commercial properties. Within these real estate asset classes, they may further diversify by investing in single-family rental homes, multi-family properties, warehouses, storage facilities, office buildings and vacant land.
In addition to diversifying with different types of real estate, investors may try to spread their investments across a variety of geographic regions. For example, a diversified real estate portfolio may consist of Midwestern single-family homes, Southeastern multi-family properties, Northeastern storage facilities and West Coast office buildings.
Another approach to diversifying real estate investments is to focus on risk rather than asset type or location. With this method, investors seek to balance portfolios between riskier investments and low-risk investments.
More specifically, a real estate investor seeking to diversify risk will try to balance properties that have high potential for price appreciation but limited or uncertain income-generating ability with those that can generate steady income but aren’t likely to appreciate a great deal.
The exact amount of risk desirable in a portfolio depends on the individual investor’s risk tolerance. Some investors are more willing to gamble on selling at a profit, while others prefer to put their money into investments that will produce reliable income.
Rebalancing Real Estate Portfolios
An individual’s risk tolerance may change over time. For instance, as individuals get closer to retirement age, they may become more risk-averse. The risk in a diversified real estate portfolio may also change as properties appreciate or depreciate in value or ability to generate income. When either of these happens, a real estate portfolio may need to be rebalanced in order to maintain an appropriate level of diversification.
Depending on how the investor chooses to invest in real estate, rebalancing can be simple or complicated. Rebalancing is easy for investors who participate in real estate by buying shares in publicly traded real estate investment trusts (REITs). REITs come in many varieties focusing on different real estate asset classes.
A REIT investor whose portfolio develops an imbalance can bring it back into shape by buying and selling shares of different REITs. For instance, if the portfolio is too heavy in REITs invested in high-end office properties, the investors can sell those shares and purchase shares in a REIT that invests in residential assets.
Investors who take a more active role in their real estate investments face a more challenging rebalancing task. They may need to sell individual properties that are affecting the mix of diversity and then buy others that will bring the risk profile back into line.
Individual real estate properties are not as liquid as securities such as shares in a REIT. Buying and selling individual real estate properties can take time, require additional investment to make properties ready for sale and involve considerable transaction costs.
Buying and selling individual properties also can have significant tax consequences compared to trading securities. Using 1031 exchanges can help investors defer paying capital gains taxes when they sell a property to help diversify, as long as proceeds are used to purchase a similar property.
The Bottom Line
A well-diversified real estate investment portfolio often includes a mix of different types of real estate, such as residential and commercial, as well as being spread across different geographical regions. Diversification also involves balancing riskier real estate investments with less-risky types.
Real Estate Investing Tips
- A financial advisor can help with the decisions involved in diversification. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s asset allocation calculator is a free online tool that can help you determine the appropriate mix between stocks, bonds and cash for your portfolio. The tool lets investors choose one of five risk profiles from very aggressive to very conservative and indicates the percentage of assets to be invested in each class.
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