Diversification and compromise
By: J. David Chapman/November 4, 2021
My wife and I have been investing in real estate for over 20 years. When we began, we were not strategic and we simply looked for deals that would cash-flow with very little consideration on type or location. I rarely sold an investment property. As my education in real estate grew, we started being much more strategic and sophisticated, considering location and type of property as a method of diversification.
Diversification is a term we most often associate with financial planners and stockbrokers. You almost never hear it when visiting with real estate investors. The goal of diversification, regardless of the investment, is to reduce the investor’s overall risk.
Diversification in real estate is most commonly achieved by investing in income-producing properties in different markets around the city, state, country, or world. It’s diversification and risk reduction by geography. The idea is that geographic diversification in real estate will limit the risk of most weather-related, terrorist-related, civil-uprising, and economic events. This has not proven to be so effective under the pandemic circumstances. Seems no place in the world was spared the hell that is COVID-19.
The latest diversification tactic is by size of city. Many investors have found that the performance of secondary cities such as Oklahoma City and Tulsa will behave differently to adverse circumstances than large cities such as San Francisco, Los Angeles, and New York City. This has certainly been the case with the COVID pandemic. This should prove to be advantageous for investment in smaller, less-dense, secondary cities.
My most popular diversification strategy is type of property. Because I find location and size of market extremely inconvenient and expensive to manage, type of property seems to be the technique most appropriate for me. We have primarily invested in single and multifamily residential, short-term rentals, and single and multi-tenant office. To broaden our diversity, we have recently added small micro-retail product and small industrial properties to our portfolio.
Finally, it is important to remember while diversification is a risk-reduction technique, it is also a bit of a hedging effort. Because of this hedging characteristic, it tends to reduce both the upside and downside potential of your portfolio. That might sound a little counterintuitive, but remember your purpose of diversity is to protect your investment in your real estate portfolio under a range of economic conditions but, by doing so, you may also limit your profit potential. Welcome to compromise.
J. David Chapman is professor of finance and real estate at the University of Central Oklahoma (jchapman7@uco.edu).