DIVERSIFYING YOUR COMMERCIAL REAL ESTATE PORTFOLIO: WHY and HOW
Commercial Real Estate (CRE) investment provides savvy investors a wealth of advantages. Tax benefits, cash flow, and leverage among them.
One issue that investors should be attuned to, however, is diversification. Diversification in the stock and bond markets is widely understood and practiced, but when it comes to real estate; many investor portfolios lack proper diversification. Often, they are filled with the latest trend or boom properties even though the particular cycle may be getting long in the tooth. The causes for this lack of diversification range from lack of knowledge of both the benefits of diversification and how to obtain it while investing in commercial real estate.
Diversification is simply allocating your investments among different styles and types of asset classes. In layman’s terms it is the act of not putting all your eggs in one basket. In the stock market, diversification would include investing some of your money in stocks, and some of your money in fixed income (e.g. municipal bonds). Further still, within the stock investments and investor might put some of the investments within blue chip stocks, some in growth stocks (say technology) stocks in foreign markets.
A commercial real estate portfolio can also be diversified with different types of property types or asset classes. The primary categories of property types are; multi-family housing (apartments), industrial, retail, hospitality (hotels) and office buildings. Each of these categories has a unique risk-reward profile and may be well suited to particular economic and demographic cycles.
Why is Diversifying Your Portfolio Important in Real Estate Investing?
The obvious advantage is that if a specific investment does not do well, other investments in the portfolio that are performing better can dampen the overall risk of the portfolio. As an example, during a bear market if stocks were to lose nearly half of their value (which has happened twice since the turn of the century) by investing half of one’s money in fixed income, an investor’s portfolio would only be down around 20 percent or so.
The same concept applies to real estate investing, but as the real estate market tends to be more fragmented than stocks, it is a concept that is not as well known or practiced. In addition, many investors think of real estate itself as diversification, which is true; but within real estate as a broad class there are many options. By utilizing effective diversification technique an investor can lower the overall risk.
An underappreciated benefit of diversification is that by lowering the risk profile, an investor may be able to actually increase returns. Of course, this sounds backwards as everyone knows that lower risk mean lower potential returns and vice versa. However Modern Portfolio Theory (MPT) has taught us that by diversifying away the individual risk of investments an investor may be able to take on more risk from an overall perspective and thus also earn higher returns. This is of course an extremely simplified discussion of MPT, but the overall point stands.
Sign up to learn more about how to invest in office buildings and to get early access to our next investment opportunity.
How to Diversify Your Commercial Real Estate Portfolio
Similar to stocks, the logistics of real estate investing can make diversification challenging. When any given real estate investment requires a substantial minimum investment, it is harder to spread the eggs around.
When an investor does diversify however, here are several ways to spread out real estate investments. The first would be by property type i.e. multi-family housing versus office. The second way would be to diversify geographically. Different regions and cities can experience vastly different economic conditions and thus experience greatly differing real estate market dynamics at any given time. Yet another, sometimes overlooked way to diversify is through the risk class of an investment.
Asset Class Portfolio Diversification
Different classes will have differing investment characteristics, risk profiles, and will perform differently in various markets. The following are some of the major classes.
Multi-family Housing – Multi-family housing is more commonly known as apartment buildings. From a high-rise downtown apartment building to a rural two-story garden apartment, multi-family housing is one of the staples of commercial real estate investing. The styles and amenities of apartment properties range from luxurious to those targeted towards lower income and subsidized housing. Accordingly, the amount of maintenance and management costs will vary greatly as well.
A unique aspect of multi-family housing is the short lease term, typically one year. This allows rents to keep pace with current market rates, which can be particularly useful during inflationary periods to keep up with rising expenses. Another characteristic is that the larger properties have numerous tenants and any particular vacancy will not have a dramatic effect on the performance of the investment.
Drivers of multifamily housing are typically local economic and demographic trends, combined with home prices and employment factors.
Retail – Commercial real estate in the retail category consists of malls, strip malls or shopping centers. Tenants of these property types include big box anchor stores for shopping center such as a Home Depot, Best Buy, Barnes & Noble or large fitness centers and restaurants can also be key tenants. In the shopping mall space, major tenants such as Nordstrom and Macy’s serve as anchors. The major tenant of a smaller strip mall may be a residential real estate firm, pharmacy or grocery store. This sector has, as you know, been particularly hard hit by the move to online shopping and is generally in a state of decline. Nevertheless, there are some retail opportunities for “Amazon-resistant” retail such as entertainment, restaurants, etc.
Industrial – This class is made up of facilities such as warehousing/distribution centers, manufacturing plants and similar facilities. Typically, each property has a single tenant and while overall overhead may be relatively low upfront costs in the form of modifications and buildouts can be not only extensive and costly; but unique to a specific tenant and must be re-worked for a new tenant if an existing lessor leaves. Lease terms are longer typically 10 years or longer which is good from a stability standpoint but can be a potential issue if rents lag current market rates. Other risk factors for industrial properties are the risk of a single tenant should they leave or run into trouble, and that these properties tend to be more economically sensitive or at least the first to feel the pain of an economic downturn compared to other types.
Industrial assets, in contrast to retail, have been a primary beneficiary of the move to online shopping as vast distribution centers, housed in these industrial centers, have taken the place of the pedestrian shopping areas.
Office – Office properties include city skyscrapers all the way down to smaller buildings with one or two tenants. These buildings are classified as A, B or C properties. As one would guess a Class A building is the highest caliber, new (or newly renovated) major building with state of the art logistics and amenities such as restaurant and/or retail space, along with an ample ratio of parking spaces to expected occupancy or “population” of the building. Typically occupied by high profile credit-worthy firms.
Class B buildings are a bit older, may have been considered Class A at one point but now slightly dated in terms of infrastructure and amenities. They could also be newer construction but smaller in scale and weaker in location compared to Class A.
Class C buildings are typically older buildings with infrastructure and technology that while not obsolete, is significantly dated. These buildings are sometimes targeted for re-development and upgrade to potential Class B type buildings.
Office properties that contain any smaller to medium-sized tenants with medium to long term leases, can be more stable investments than other asset classes because they enjoy diversification within their own tenant mix and lease terms. Office space performance is driven by regional demographics and economic factors. As these factors may buck national or global trends, office space investing can provide an excellent way to diversify real estate holdings.
A unique aspect of commercial real estate investing is the ability to get diversification geographically. In the stock market, companies and industries do have a multitude of issues affecting them and are also greatly affected as a whole by general market conditions. In real estate, however, economic and demographic conditions can vary greatly from market to market which provides numerous opportunities for specialized returns as well as the chance to spread the risk around.
At Feldman Equities, we invest in fast growing secondary markets that may become primary markets.
Risk-Class Portfolio Diversification
When acquiring commercial real estate, there are three broad classifications of real estate investments.
Core Properties – These are the cream of the crop in terms of property. Premium properties in premium locations earning premium rents. These core properties provide strong and stable cash flow. The downside however is the prime assets and cash flows do not come cheap. As such, while these investments are safer than other categories, they will come with a lower expected return (not unlike Blue chip stocks). They do provide downside protection in difficult times. Given that these properties ore often very large they are often owned by well capitalized institutional investors and/or Real Estate Investment Trusts (REITs).
Core-Plus – These properties are similar to Core properties but are not quite prime assets. Buildings may be older or not in a prime location. The tenant roster may be a little riskier. They may have shorter-term leases and somewhat less credit-worthy tenants versus a “Core” property, which make them more sensitive to economic downturns. Given that there is modestly more risk in a Core-Plus property the expected return is a bit higher. In some cases, core-plus assets can be converted into core assets through renovation. This a strategy which Feldman Equities employs to create value.
Value Added – These properties come with one or more issues that need to be addressed. Assuming the right skill set, these issues become opportunities for a new investor to fix. Value-Add commercial real estate usually earns a higher return than is possible than on Core or Core Plus properties. Examples of such issues may include a significant vacancy. In retail in particular, the loss or poor performance of an anchor tenant has a cascading effect on the other tenants and rents. Bringing in a new and successful anchor tenant can have a significant influence on the rental rates of the remaining space. In office space or multi-family housing, performance and returns can sometimes be enhanced through more effective property management, extensive renovations or making necessary repairs. Value-Add acquisitions typically involve more substantial investments, in order to achieve higher rents and occupancy.
Again, this asset class is one in which Feldman Equities specializes. We prefer to buy very well-located office buildings in rapidly growing markets, which we can buy at a significant discount to replacement cost. Prior to committing to an acquisition, we estimate the entire cost of the renovation, tenant improvements, the cost of repairs, marketing costs and other lease-up costs. All of the aforementioned costs are added to the acquisition cost. We then compare our projected total investment to our projected stabilized net operating income. Ideally that yield will be approximately 8.5% at stabilization. Based upon today’s low interest rates at around 4%, we know that this yield will result in a profitable investment.
Distressed – Properties that have major issues that need to be fixed, which may also require and owner with specialized expertise sometimes in finance. These properties are sometime acquired in foreclosure or foreclosure is sometimes pursued after distressed debt on the property has been acquired. Other cases may involve deep discounted purchases of a property that needs significant or complete overhaul and rebuild. These projects offer the greatest risk reward profile, and the opportunities are sometime the result of a previous market boom turned to bust, including unfinished development projects that may be salvaged or repurposed.
One of the challenges that individual real estate investors face when seeking to diversify is that real estate investments require significant investment, even minimum investments on private deals and limited partnerships can be substantial and make it difficult to get exposure to a variety of asset types.
One potential way around this is the use of Real Estate Investment Trusts (REITs). A REIT is a company that owns and manages a portfolio of real estate properties and is registered with the Securities and Exchange Commission (SEC). While there are a growing number of private REITs, most are publicly traded on stock market exchanges. REITs offer an investor an easy and quick method to get exposure in (or out) of real estate, and if desired for significantly smaller dollar amounts of investments. Many REITs will focus on a specific niche or type of property where the management has specialized expertise in a particular asset class or geography.
Since REITs trade like a stock it is possible to get wide exposure to a variety of asset types, and classifications with a relatively small investment. While REITs do provide liquidity and diversification there are a few drawbacks. To qualify as a REIT the company must distributed 90% of its income to the shareholders, which can prevent or limit longer term re-investment by the company itself. REITs often focus more on Core type holdings, which are good and stable, but may not provide the potential returns available through more Value-Add and distressed investments can. Even if not distressed there are many good opportunities that are just not big enough to affect a REIT and may be better accessed by individual investors through fractional ownership in limited partnerships via real estate syndication.
With the long-term decline in interest rates, the prices of REITs have been bid up sharply, making the yields on these investments somewhat less attractive. Although REITs provide maximum liquidity, a recent quote for the IYR (the leading REIT ETF) indicated a yield of approximately 2.65%.
Limited Partnerships and Crowd Sourcing for Portfolio Diversification
Another way an individual investor may obtain diversification is by pooling money with other investors through the use of syndication via limited partnerships and increasingly through the use of crowdsourcing syndications that allow minimum investments that are substantially smaller than is traditional typical in commercial real estate.
Another advantage of these smaller investments is that they have the ability to take on smaller properties or unique opportunities and expertise in specific markets that large institutional and REITs would not bother to touch. Many of these investments will utilize an ownership structure that passes through the tax benefits of real estate directly to the fractional owner.
Interestingly, the legal structure of a crowdfunded real estate deal is almost the same legal structure that has been around for 40 or 50 years. In most crowdfunded offerings, the investor must be verified as an accredited investor and the sponsor notifies the SEC of the syndication through a filing.
The individual accredited or high net worth investor has the benefit of being able to focus on one particular property that the investor has a high confidence in. In contrast, a REIT owns a broad range of properties whose value may be more difficult to ascertain.
The sponsor of a crowdfunded transaction is not subjected to the onerous expenses that a public company incurs and therefore is able to provide a higher yield to the investor than such investor might otherwise obtain in a public REIT.
How Does Diversifying Your Commercial Real Estate Portfolio Reduce Risk?
A well-diversified CRE portfolio will protect an investor from over exposure to a specific property type when economic and/or demographic cycles change. As an example, the advent of Amazon and online shopping created significant market pressures for retail investments. A portfolio that was overly exposed to retail could have been protected by also having exposure to multi-family housing, industrial, and office type projects. More recent trends have seen booms with industrial – due to the warehousing and distribution centers required for the online economy. Multi-family housing has also been a hot segment. Millions of millennials have moved into urban centers and have opted to rent rather than buy.
While these categories may have performed well, success often leads to oversaturation of the market. The supply of new construction for apartments and industrial buildings has reached very high levels. Commercial real estate investors may be wise to look to other areas such as office or other asset classes, which are experiencing very modest new supply.
How Much Money Do You Need to Diversify Your Portfolio?
The amount of money required to achieve real estate diversification depends on the type of investments an investor chooses to utilize. One could achieve broad diversification by investing in a handful of shares in numerous REITs (or through the purchase of a broad-based Exchange Traded Fund (ETF) that in turn invests in REITs.
Historically, to obtain access to limited partnership or private equity type investments in commercial real estate, on would need to be an accredited investor (general describes as someone with a net worth greater than $1,000,000 or with an annual income of at least $200,000 a year) and make six figure minimum investments to a particular partnership or property, which would make it difficult for even wealthy investors to truly diversify real estate holdings.
Recently driven by the advent of crowdsourcing, it is possible for investors to obtain access to institutional style real estate investments with significantly smaller minimum investments than has been historically required.
Diversification within commercial real estate can be a key ingredient of risk management. By avoiding a highly concentrated investment on only one or two specific properties, an investor may be able to mitigate risk and increase long-term returns. In short proper diversification can allow an investor to have his (or her) cake and eat it too.
Traditionally diversification has been somewhat difficult to achieve in commercial real estate, but with the use of REITs or real estate syndications investors can move into different areas, and to avoid the mistake of jumping into the latest fad or trend after a specific cycle or boom is getting a bit tired.
View our portfolio at Feldman Equities to learn more about our commercial real estate properties.
The pandemic is likely to have a lasting effect on the office market.
It’s possible that working from home may become the new normal for some businesses. However, many office users are learning that virtual meetings simply don’t provide the same opportunities to collaborate, nurture creativity, and attract the skilled employees businesses need to succeed.
The Covid-19 pandemic has forced governments around the world to close down their local economies. As a result, lower consumer spending and decreased business operations are creating unique challenges for office building owners and operators.
Commercial real estate is generally considered one of the best ways for individuals to grow their net worth. That doesn’t mean commercial real estate investing is foolproof. One of the ways that some investors get tripped up is that they fail to do their due diligence before investing their hard-earned dollars.