Diversifying a portfolio by investing in real estate can help manage risk and potentially improve long-term returns. It can also increase your portfolio’s income and capital appreciation. Real estate investments can be diversified by investing in different types of real estate and different geographic regions, and by balancing riskier real estate investments against less risky ones. If you need help building a diversified real estate portfolio, you should consider working with a financial advisor.
Diversifying a portfolio helps reduce risk and improve returns. One way to do this is to spread investment funds across multiple asset classes. Asset classes include cash, commodities, art and collectibles, in addition to real estate, stocks and fixed income.
A diversified portfolio includes investments in multiple asset classes. For example, investing in real estate can add diversification to a portfolio otherwise invested in stocks and bonds. Real estate is a particularly effective asset for diversification because it is not closely correlated with the securities markets. When stocks and bonds fall, real estate can rise and vice versa. In this way, diversification helps investors minimize losses due to broad market trends.
In addition to diversification across asset classes, investors often also seek diversification within asset classes. For example, the equity portion of a portfolio may be divided into investments in domestic large capitalization stocks, domestic small capitalization stocks, international stocks, emerging market stocks, and so on. This further diversification reinforces the risk-reducing effects of diversification.
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Real estate diversification
Real estate investment diversification can take many forms. One way is to invest in different types of real estate. For example, investors can invest money in both residential and commercial real estate. Within these real estate asset classes, they can further diversify by investing in single-family homes, multi-family homes, warehouses, storage rooms, office buildings, and vacant lots.
In addition to diversifying with different types of real estate, investors can seek to spread their investments across a variety of geographic regions. For example, a diversified real estate portfolio may consist of single-family homes in the Midwest, multi-family homes in the Southeast, storage facilities in the Northeast, and office buildings on the West Coast.
Another approach to diversifying real estate investments is to focus on risk rather than asset type or location. Investors use this method to try to balance portfolios between riskier assets and lower-risk assets.
More specifically, a real estate investor looking to diversify risk will seek to balance properties with high potential for price increases but limited or uncertain earning capabilities with properties that can generate consistent income but are unlikely to generate much appreciation in value.
The exact level of risk that is desirable in a portfolio depends on the risk tolerance of the individual investor. Some investors prefer profitable sales, while others prefer to invest their money in investments that provide reliable income.
Rebalancing of real estate portfolios
A person’s tolerance for risk can change over time. For example, the closer people get to retirement age, the more risk-averse they become. Risk in a diversified real estate portfolio may also change as real estate appreciates or depreciates in value or in its ability to generate income. When either of these occurs, a real estate portfolio may need to be rebalanced to maintain an appropriate level of diversification.
Depending on how the investor invests in real estate, rebalancing can be simple or complex. Rebalancing is easy for investors who get exposure to real estate by buying shares in publicly traded real estate investment trusts (REITs). REITs come in many flavors that focus on different real estate asset classes.
A REIT investor with an unbalanced portfolio can rebalance it by buying and selling shares in different REITs. For example, if the portfolio is overweight in REITs that invest in high-quality office real estate, investors can sell those shares and buy shares in a REIT that invests in residential real estate.
Investors taking a more active role in their real estate investments face a more difficult rebalancing task. They may need to sell individual properties that impact the diversity mix and then buy others that bring the risk profile back into line.
Individual properties are not as liquid as securities such as shares in a REIT. Buying and selling individual properties can take time, require additional investments to get the properties ready for sale, and involve significant transaction costs.
Buying and selling individual properties can also have significant tax implications compared to trading in securities. Using 1031 exchanges can help investors defer paying capital gains taxes when selling a property to help diversify as long as the proceeds are used to purchase a similar property.
The final result
A well-diversified real estate investment portfolio often includes a mix of different types of real estate, e.g. B. residential and commercial real estate, and is spread over different geographic regions. Diversification also involves balancing riskier real estate investments with less risky types.
Real estate investment tips
A financial advisor can help with diversification decisions. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool puts you in touch with up to three financial advisors operating in your area and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
SmartAsset’s asset allocation calculator is a free online tool to help you determine the right mix of stocks, bonds and cash for your portfolio. The tool lets investors choose one of five risk profiles, ranging from very aggressive to very conservative, and specifies the percentage of assets to invest in each class.
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The How to Build a Diversified Real Estate Portfolio post first appeared on the SmartAsset Blog.