The journey of investing can be very fruitful, however, as in everything in life, things change, hopefully for the better, and sometimes toward the unexpected. The generation of income is one of those factors that is likely to be effected by change. It can go up, it can go down, and it can virtually disappear depending on your investment position. Even the wisest investors get blindsided by events. This is why diversification is key in growing your investments.
As an investor, you will be faced with unsystematic risk, or the risk associated with the inherent uncertainty in business. Unsystematic risk, also known as specific risk, is made up of the risks that are unique to a specific market ie; the internet changing retail patterns, co-working changing office building construction. One of the best ways to manage these risks and keep the uncertainty to a manageable level is to diversify your portfolio. In the first half of this article, I will outline the potential threats to each asset class. In part two, I will provide a brief overview on how an investor can diversify a portfolio to better prepare for and balance out risks.
Threats to Each Asset Type
There are five main asset types, or property types, discussed herein that a person can invest in. These include retail, multi-family, office, industrial, and residential. Each property type faces a different set of threats that have to be accounted for.
Retail: Retail properties are haunted by the rise of e-commerce business and frequent changes in consumer behaviors. These factors can alter the success of a business, good or bad, depending on the tenant’s relevance to its customers. What’s more is that the retail leases are usually for longer terms and may not have the flexibly that the tenant needs. With retail evolving, a retail property income and value may be at fluctuate.
Multi-Family: Multi-family real estate investments, however, face a different risks; one being rent control. Rent control refers to the ordinances and laws that set price controls for residential housing. This also includes restrictions on how to manage the property. Restrictions on rent mean that investors face limits on the rate at which they can raise their tenants’ rents, which can make it difficult for an investor to achieve their desired return on an investment and more importantly in turn will also effect the ability of a property to increase in value.
Office: Similar to the challenges faced by retail spaces are those of office investment properties, which face a new kind of competition as well. Today’s market is seeing an influx in coworking spaces, which has ultimately created a decline in demand for traditional office space. More companies are transitioning to remote working as well, a trend which drives office buildings to shift their business models to adapt.
Industrial: This sector has experienced major changes in recent years. As e-commerce transactions have increased, more demand for industrial space has been required. However, anticipated changes in income, supply chain trends, and trade policies can negatively impact the demand.
Residential: There are numerous risks to residential homes. The most prevalent in today’s market include changes in construction regulations and lending terms. Unfavorable policies and terms can make it difficult for investors to experience positive cash flow on their residential units.
This is just a glimpse at the risks associated with the individual sectors; however, there are many more since all markets are constantly shifting.
How to Diversify?
There are various ways an investor can diversify their portfolio of investments, which will strengthen their ability to withstand the weaknesses of any one investment type — some of which I outlined above. Here are some options:
- Invest in a variety of asset classes. Get invested in retail, multi-family, office, industrial, and residential properties. Then, when unexpected changes inevitably happen in one sector, it won’t protect you from a bigger downside while the rest of your portfolio continues to grow.
- Diversify within a single asset type. For example, when investing in retail spaces, purchase multi-tenant and single tenant buildings, and diversify by making sure the tenants within the properties represent multiple industries. Tenants might include banks, restaurants, auto-stores, drug stores, etc. Another useful approach is to make sure that, when investing in office space, you look at class A, B, and C office space.
- Focus on both cash flow models and appreciation models when developing your investment strategy. This can allow you to take risks in your cash-flow model while preserving capital in your appreciation-focused model.
- Consider investing in different markets. Seek out opportunities in growing cities, consider going out of state as well, and build a presence in multiple markets are three examples, This can help you avoid excessive loss due to unforeseen circumstances such as natural disasters or changes in government ordinances.
- Go international. Investing in markets like Sydney, for example, can provide a different set of benefits and risks. However, before proceeding, be sure to completely understand the relevant laws in the country you chose as oversights in different regulations and laws can prove costly.
- Participate in a syndication. This can allow you to invest in deals that another investment firm located.
- Invest in a real estate fund, bonds, or stocks. These are more passive investments that can provide you with liquidity and depending on the fund, equity and debt diversification.
Why Diversify?
Diversification is an invisible shield. It offers you flexibility in the constantly changing market and can assist in minimizing the risk of loss. For example, if one investment is performing poorly, you have another thriving investment that offsets your losses. One day, the tables will probably turn, and the once-struggling investment will anchor your portfolio while another asset takes a less favorable turn. In addition, you can participate in different strategies, including those that require no management on your end. A well-diversified portfolio can improve the chance of ongoing growth.
