Although it does not guarantee against loss, diversification is arguably the most important component of reaching your long-term financial goals while minimizing risk. Diversification is simply the practice of spreading your investments around so that your exposure to any one type of asset is limited.
Although the exact percentage may vary depending on who you ask, it’s generally accepted that between 10-30% of a high-net-worth investor’s portfolio should be in alternatives, which includes commercial real estate. Adding commercial real estate offerings to your portfolio, in addition to the usual stock and bonds, helps diversify your overall investment strategy. But it’s not as simple as just pumping a percentage of funds into commercial real estate. Just like you invest in a variety of stocks and bonds, you can also diversify amongst your investments to help reduce the volatility of your portfolio over time.
Commercial real estate diversification can take many forms but here are five ways to think about it:
Diversify by investment amounts
Historically, only the ultra-wealthy and incredibly connected had the opportunity to invest $200k (or more) to get access to a single private real estate deal. But thanks to the advent of online commercial real estate investing, investors now have access to deals at far lower investment amounts, sometimes as low as $25,000. This means that you can invest in multiple offerings with various amounts–$15k in one, $35k in another, etc. Even if one deal underperforms, your other investments can help minimize risk and protect your overall rate of return.
Diversify by sponsorship
There are hundreds, if not thousands, of quality operators across the U.S. Look for experienced groups with solid track records and then consider spreading your investments amongst them. Working with different sponsors will also help ensure you invest in different regions and different asset classes, each with its own unique benefits and opportunities.
Diversify by geography
You can diversify your investments by looking for deals in different neighborhoods, cities, states, and regions. Remember, real estate is hyper-local and each geographical area has its own opportunities and drawbacks, and certain areas are likely better for different sectors based on demand for an asset type. For instance, if you are thinking about investing in multifamily properties, you probably want to look for deals in markets with a growing population and above-average job growth. Meanwhile, big businesses opening (or closing) their headquarters in a city can rapidly change the long-term value of an office park in that market.
Diversify by asset classes.
Commercial real estate is more than just multifamily (although many investors start with that asset class because it’s the most familiar), and each asset class has its own market cycle and nuances. Take retail for example. A few years ago, the conventional wisdom was that brick-and-mortar retail was dead because Amazon taking over the retail world, and this perception led to a drop in asset prices. But then Amazon acquired Whole Foods and began opening its own branded brick-and-mortar retail locations. Other e-commerce sites like Warby Parker and ModCloth have also opened physical stores. And in the last few years, we’ve seen brick-and-mortar retail adapt to an increasingly online world by morphing into micro-distribution centers. This phenomenon now puts retail into an interesting, and perhaps undervalued position in the commercial real estate market. If retail somehow gets recast as “last ¼ mile distribution” in the next few years, the market pricing could spike.
Diversify by the business plan.
Some deals are intended to be high-risk, high-return. Ground-up development or the repositioning of an asset may have a higher IRR, but they often come with a higher risk–a lot of things have to go right in order to see that rate of return. Other business plans may focus on a stabilized asset where things are going well, and the plan is to maintain the asset’s position in the market. As you assemble your commercial real estate portfolio, it’s important to blend across different business plans with different risk levels.