Jul 07 2021

A Guide to Portfolio Diversification using Real Estate

Abigail Ng

“It’s never a good idea to put all your eggs in one basket.”. This is a common recommendation by investment gurus, but what does it exactly entail?

The Concept of Diversification

An investment portfolio is a consolidation of various assets including stocks, bonds, cash and real estate. Each investment portfolio takes into account an individual’s risk tolerance, and investment horizon to formulate a suitable mix of assets.

Diversification of your investment portfolio helps minimise idiosyncratic risk by reducing risk exposure to a single asset and distributing it across various investment products. Diversification is one of the core principles of portfolio management that reduces risk and attains a consistent overall growth of your investments.

Real Estate as a tool of diversification

Real estate plays a key role in the portfolio, generating stable risk-adjusted returns which in turn helps ensure sustainable growth of an investment portfolio.

Here are three reasons why you should including real estate in a multi-asset portfolio:

1. Real estate has a low correlation with stocks and bonds.
2. Real estate has historically had a higher risk-adjusted rate of return relative to stocks and bonds.
3. Real estate has a positive correlation with both anticipated and unanticipated inflation and therefore provides an inflation hedge.

Based on recent studies, 10-20% of allocation into alternative assets such as Real Estate is recommended for diversification of risk in a multi-asset portfolio. As opposed to more volatile assets such as stocks or cryptocurrency, the real estate market is generally slow-moving and stable.

On top of gaining exposure to real estate, there are several ways diversification can be achieved within the asset class.

How to Diversify your Real Estate Assets?

There is a myriad of ways in which Real Estate can be further classified and diversified. Investors can distribute their risks across various categories like risk profiles, asset types, and geographical locations.

1. Diversifying by Investment Strategy

Figure 1. Investment Strategy Risk Classifications (Source: Fraxtor)

Another great way to diversify your portfolio is to change up your investment strategy and holding time. This graph shows the risk-return profiles of various investment strategies in the private equity space. There are four primary strategy categories, each differing based on their risk and return profiles. Diversifying property investments throughout these categories can help ensure steady returns.

These categories are:

• Core
• Core-Plus
• Value-Add
• Opportunistic

Core

Core properties refer to high-quality real estate characterised by highly predictable rental cash flows and long-term leases. These properties are in good shape, requiring little to no renovations, and are commonly located in major markets with strong demand drivers and underlying fundamentals. Such assets are thus usually recognised to weather through economic downturns.

However, due to the high valuation of core properties, the majority of the expected return is likely to be generated through cash flow from the property rather than capital appreciation. Its conservative nature might appeal to investors desiring more stable and predictable returns, such as Real Estate Investment Trusts (REIT).

Core-Plus

Known as ‘growth and income’ investments, these properties have a low to moderate risk profile. Similar to core properties, these properties tend to be high-quality and well-occupied. One potential downside is that the cash flow is less predictable than a core investment, and these properties require active asset management. Core-plus property owners typically have the ability to increase cash flows through light property improvements, management efficiencies, or by increasing the quality of the tenants.

Similar to Core properties, the primary source of returns for Core-plus properties tends to be driven by the rental yield instead of capital appreciation.

Value-Add

With a moderate to high risk profile, value-add properties are typically faced with occupancy issues, deferred maintenance, and management challenges. They often have little to no cash flow at acquisition. However, there is a huge potential to generate returns with some Asset-Enhancements Initiatives (AEI). With the selective remodeling of the existing property, they have the potential to drive operating revenue growth and capital value appreciation.

The Value-Add strategy requires a deep knowledge of real estate, strategic planning, and close monitoring. Hence, they are recommended for seasoned real estate investors only.

Opportunistic

This opportunistic risk profile presents the most risk, alongside the highest opportunity for returns. Opportunistic strategies typically involve complicated projects that require years of experience and a team of real estate professionals to be successful. Examples of Opportunistic strategies include ground-up developments, acquisition of an unoccupied building, repositioning a building from one use to another.

Despite Opportunistic investments generating little to no cash flow from the offset, they have the opportunity for massive returns through capital appreciation.

2. By Asset Type

The vast asset options presented to investors range from residential, industrial to commercial, and hospitality. Investing in a wide range of different real estate acts to hedge against macroeconomic fluctuations. One prominent example is how the global pandemic harshly impacted hospitality and retail REITs and yet brought tailwinds for industrial and data centre REITs. Investing across multiple property types can help manage concentration risk.

Residential

The 2 main residential property classifications are landed and non-landed properties, which further branch out to many more specific types.

Landed Residential Properties: Bungalows/Detached, Semi-Detached, Terraces, Cluster houses
Non-Landed Residential Properties: Apartments, Condominiums, Public Flats

Direct investment into residential properties is very common. Typically, investors purchase property in hope of a windfall when value increases or for stable income through rentals. To curb investors from artificially inflating residential property prices, certain governments around the world have measures in place to discourage speculations.

For example, the Singapore government has measures such as additional buyer stamp duties and seller stamp duties imposed, while some European countries have rent controls.

Industrial

Industrial real estate generally involves properties purposed for manufacturing, storage and production, such as factories or logistics centres. Industrial properties often have significantly longer leases up to 10 years, which increases the investment security for investors. Tenants often allocate substantial operation funds for repurposing or retrofitting the space.

Due to the nature of industrial activities, these spaces are usually larger, limiting access to individual investors due to the sheer capital outlay. Despite that, the ability to command high rental rates and hence greater potential for higher yields is rather attractive to investors. Typically, industrial property rentals can fetch roughly about double what residential properties can.

Commercial

Commercial real estates are properties for business purposes, of which profits are generated. The most commonly known from this classification are office buildings and retail malls. Similar to industrial properties, they command higher prices as compared to residential properties, requiring high capital outlay and hence not as friendly for individual investors who wish to invest directly. These properties usually have leases averaging from 3 to 5 years and choose their tenants wisely to fit their overall concept and direction.

Alternative

Alternative real estate includes non-traditional real estate types, such as nursing homes, fish farms, student accommodations, data centres. This asset type has become increasingly popular amongst real estate investors. Driven by demographic changes, as well as changes in social-economic factors and technology trends, demand for alternative real estate has grown over the years.

3. By Geographical Location

A diversified portfolio can also be achieved by looking into multiple geographical locations. It is common for investors to focus on local markets due to the increased accessibility and knowledge of the local property market. However, the dependence on a single economy increases the risk of a single event in the country or region, heavily impacting investments. Diversifying into new markets and locations acts as gateways to new economies which enhances the ability to deal with potential single economic downturns.

Furthermore, diversifying across geographical boundaries might negate the hyperlocal nature of real estate, which limits the exposure to risks associated with one particular property market. Portfolio diversification, along with market selection, helps institutional investors seek out risk-adjusted returns on their investments while minimizing concentration risk.

However, geographical diversification brings about foreign exchange risks, which may erode or amplify investment returns depending on the exchange rates at entry and exit of the investment. Geographical separation also makes it difficult for investors to manage their investments unless they are professionally managed.

Read also: How has Covid-19 impacted the Australian property market?