Experienced financial advisors point out to clients that real estate investment portfolio diversity will help reduce risk in their overall portfolio. You can achieve this in the stock market by purchasing several different stocks, or by investing in a fund that holds multiple stocks.
Diversification in real estate works much the same way.
- Investors can build a diversified portfolio by buying a variety of individual properties outright.
- Or, you can invest in one fund that owns many properties.
- It is also possible to diversify your holdings by investing in fractional interests in individual properties through what is called a syndication.
Real Estate Investment Portfolio Diversity: Sole Ownership
One of the most common reasons why people purchase rental real estate on their own is to maintain full control over the investment. Decisions about leasing, operations, capital improvements, financing and disposition are solely up to the owner. This presents benefits and disadvantages.
As a sole owner, you can pick your own tenants and set their rental rates. You can also discuss any of their requests for concessions, such as rent abatement or improvements to their premises. Property management will be among your most important operational choices. Taking a look at the creditworthiness of prospective tenants will also be key. You have the option to profit from your own sweat equity by handling maintenance and management issues yourself, or you can hire contractors or professional property managers.
Sole Ownership = Sole Responsibility
You will have to do your own due diligence to assess what type of work, if any, will be needed during your intended holding period. You can also decide to what extent you will make capital improvements to the property —improvements that will raise the value of the property. You’ll decide when to do them and how to pay for those improvements.
If you want to use leverage, you can adjust the amount and terms of the loan, including the maturity date, amortization schedule and any interest-only period to accommodate your needs. However, you will typically have to provide a personal guarantee for the debt, which can range from non-recourse “bad boy” carve-outs, or exceptions, to full personal recourse. This will depend on the borrower’s experience, credit and relationship with the lender.
Perhaps the most significant trade-off for the freedom of sole ownership is that it ties up your capital in one project. While this lack of diversification can be minimized by buying a mixed-use asset (e.g.. a storefront with offices or residential spaces on the upper floors) or a multi-tenant property, you will only have exposure to one location in one market. If that market declines due to economic, environmental or other reasons, you probably won’t have as much of a return on your investment as you had hoped.
Real Estate Investment Portfolio Diversity: Real Estate Funds
One alternative to avoid having all of your proverbial eggs in one basket is to invest in a professionally managed real estate fund. Funds can take many forms, including public or private REITs or private placements. An REIT is a real estate investment trust — a business entity that owns and operates a portfolio of real estate.
Investors buy shares in the REIT and receive periodic distributions of income, as well as their share of tax attributes relating to the real estate. This includes both income tax obligations and depreciation deductions. In this way, rather than buying real estate directly, you will acquire shares of a fund that owns the real estate.
REITs: Public vs. Private
REIT holdings can include both real estate and mortgage loans. These trusts are required to distribute 90% of their taxable income to their investors as dividends. Publicly traded REITs are traded on stock exchanges, so they provide easy liquidity. Like mutual funds, they make disclosures and public filings as required by the SEC.
There are also private REITs whose shares are not traded; those investments are illiquid. REITs are professionally managed. The properties they buy are vetted by people with experience in the real estate industry. Those people also undertake and review due diligence for the properties and their tenants. REITs often get funding from institutional investors, so the credit and quality of the underlying assets tends to be high. Reporting is provided on a prescribed basis, and financial results are usually audited by a reputable national accounting firm.
Before investing, you will receive an offering memorandum that states the following:
- The REIT’s investment criteria,
- The experience of its management,
- A description of the actual or anticipated financing and underlying real estate.
- The benefits and risks of the investment.
If the REIT is publicly held, you will be able to liquidate your investment by trading your stock at any time.
Investment Funds: Less Responsibility = Less Control, Less Say, More Fees
Besides REITS, there are also privately held real estate investment funds, where professional managers acquire, operate and dispose of properties on behalf of their investors. Such funds work in the same way as a private REIT, but do not have a legal obligation to distribute a specific percentage of income to investors.
Among the negatives of using fund investments for real estate investment portfolio diversity are the lack of any voice or control on the part of individual investors for any part of the investment, and the fees charged in comparison to those earned through sole ownership. Depending on the size and nature of the fund, assets may be bought or sold after you invest, making it harder to know exactly what properties are part of the portfolio at any point in time.
Fees will include the administrative expenses of the fund itself and compensation for fund management, as well as the cost of outside professionals involved in the acquisition, debt financing, and management of the properties. These types of funds are likely to engage professionals in larger firms with national reputations.
Real Estate Investment Portfolio Diversity: Syndication Shares the Strategy
Another alternative to diversify your real estate holdings is to invest in a private real estate syndication. Syndications are a type of investment where many unrelated parties put their funds together to acquire a property or a group of properties sharing such characteristics such as a similar location or tenant. Syndications are put together by professional sponsors who enter into contracts to do the following:
- Acquire the property
- Raise the capital
- Obtain financing
- Operate and manage the property
- Make distributions of cash flow and capital event proceeds to investors
Most syndications will spell out exactly which properties they own or will acquire ahead of accepting investor funds. Syndicated investments are commonly structured as limited liability companies, or LLCs. Investors acquire membership interests in the entity that owns the property, rather than holding title in their own names.
Unlike REITS, interests in syndications are not traded on public exchanges, and are typically illiquid. Recently, some crowdfunding sites have cropped up to provide another market for fractional interests in syndications. In these cases, the investments may have restrictions on transfers, such as prior sponsor or lender approval.
Syndication has higher returns, but you won’t see them quickly
Syndications also are not legally bound to give out a certain percentage of their income. While this may seem like a disadvantage from a cash flow standpoint, the rule allows the sponsor flexibility to form reserves or to pay for unanticipated expenses out of cash flow instead of making a capital call.
Typical returns for syndications are higher than yields on a REIT investment. Depending on the size and sophistication of the sponsor and the structure of the investment, as well your percentage interest in relation to the total equity, individual investors may have direct communication with the sponsor to talk about property operations. Additionally, sponsors may have more flexibility regarding the timing and nature of the investment’s disposition strategy than a REIT or fund, as these are not tied to a fixed fund liquidation date.
It’s Your Money, and Your Call
There are a number of alternatives to help with real estate investment portfolio diversity. All real estate investments involve risk, beginning with the level of experience and integrity of the individuals acquiring, managing and selling the assets. The party could be you or outside professionals. In any case, it is important for you to do your own due diligence to understand the risks, costs and potential rewards of your investment.
