You probably already know that developing a solid commercial investment strategy is critical to your success. And you’ve probably also heard that diversification on your CRE portfolio is one way to evaluate the risks and increase the potential returns of your commercial income properties.
What you probably don’t know is that diversification is more than buying different types of commercial properties. True diversification includes more than property type.
In fact, there are numerous ways you can diversify your triple net lease properties that allow you flexibility and control of your assets.
The risk factors of a property can vary widely depending on the location. There are varying factors which affect a commercial property’s market desirability. These same factors can differ depending on the underlying economy of each area.
For example, metro areas can differ radically from suburban areas, and both can differ from a similar area in another region.
By choosing 1031 exchanges, in different geographic locations, you take advantage of regional, submarket, and metro differences that allow you to choose the level of risk that best fits your portfolio.
Diversification can also occur by choosing differing market types. There are primary, secondary, or tertiary markets. In the commercial real estate, markets are defined by the size of their Metropolitan Statistical Area (MSA), which refers to a high population density at its core. Primary markets for commercial real estate include New York City, Los Angeles, Chicago and San Francisco.
Keep in mind that while the most populous areas are generally considered primary markets, whether or not a particular city falls under a primary, a secondary, or tertiary market also depends on the asset type. So while New York City is generally a primary market, it would not be a primary market for resorts.
Traditionally, primary markets bring in the largest sales volume. However, choosing a secondary or tertiary market has become more popular among the investors. The lower barriers to entry, and rising occupancy and rental rates in these areas are also starting to yield a higher return.
Combined with above-average job growth, emerging technology sectors, and increased population growth, many investors view these markets as a profitable way to diversify a CRE portfolio.
Even within similar investment property types, investors can vary the lease terms in order to balance risk. For example, triple net lease properties are considered lower risk investments that offer a steady return.
If you’d like to achieve higher returns, you can always acquire single net lease properties. They have a higher risk, but they involve fewer management responsibilities and fewer owner costs.
With other commercial income property types, investors can compare tenants’ credit ratings, lease terms, and business types. A tenant’s credit ratings are determined by three public companies Moody’s, Fitch, and Standard and Poor. Credit ratings range from AAA to D, although for investment grade properties a rating of BBB is higher if necessary.
It’s also wise to match the property type with the best tenant mix possible. For example, a portfolio with a large proportion of office properties with leases due to expire within a short period of time or lower credit tenants is riskier than one with a variety of national tenants with long leases.
Economic diversification is another way of reducing risk during real estate cycle growth and recovery periods. It is based on putting cities in economic categories depending on their growth patterns over time and the dominant industry of the area.
There are nine SIC categories which provide economic diversification possibilities for investors. These nine categories are based on 316 U.S. cities categorized as MSA’s by the government.
The dominant industry of an area can be found by determining the SIC employment percentage of each industry and then comparing that result to the national average. The resulting number will tell investors which category the market falls in.
Areas that are more economically diverse are usually more stable during weak economies. And areas that are reliant on one particular industry or employer are vulnerable to economic downturns.
As an investor, you can choose to use one or several of these strategies to diversify your portfolio. Whichever strategy you select, be sure to periodically review your properties’ performance on a regular basis to accrue the greatest benefits of diversification.