If you’ve been investing in commercial real estate properties for at least a few years, then you’ve already heard about the importance of diversification.
However, although many investors know they need to diversify their portfolio because it helps reduce risk, they often assume it means buying a wide variety of properties in different asset groups.
Few realize, however, that there are numerous ways to diversify your portfolio, and even more importantly, that even diversification can be a risky endeavor if not done correctly.
Diversification By Purchasing Different Asset Types
One of the most common ways of diversifying a portfolio is by purchasing commercial properties in different asset classes. For example, an investor might choose to invest in a combination of multifamily properties, single tenant net leases, offices, and a warehouse or two.
The idea is that while a particular market may be weak, the gap in profits will be made up by an asset in a stronger market. Doing this allows investors to weather the highs and lows of each market, thus increasing their chances of making a profit on their properties as a whole.
Diversification By Investing In Properties In Different Areas
Diversifying by varying the location of the assets you own is another common strategy used by investors.
Some investors diversify by purchasing properties in primary or secondary cities; others invest in different areas of the same region, state, or city.
This is helpful not only in terms of market differences, but also to avoid being hit by a natural or manmade disaster, as well as a local economic downturn.
Primary markets offer premium properties with high-profit potential but little appreciation, but the competition in these top cities is stiff. Secondary markets offer numerous opportunities for investment, but investors need to make sure they are investing in the right type of property for the city they are interested in.
In order for this tactic to work, investors need to have extensive knowledge of the area they plan to invest in and be prepared to spend some time before, during, and after the purchase to inspect and manage the property.
A triple net lease property, on the other hand, doesn’t require an investor to manage the asset; once the initial due diligence period has completed and the purchase has gone through, there are no expenses to pay, as these are paid for by the tenant, and no management is needed.
Diversification According to Risk Profile
Another lesser known method for diversification involves diversifying a portfolio according to the risk presented by the investment property.
There are four types of categories when evaluating a property’s risk profile.
Commercial properties in the first category are termed “core assets.” These are low-risk investments feature long-term, high credit tenants. They are located in Class A neighborhoods and buildings and require little to no renovation by the owner.
At the same time, they experience little to no appreciation; however, that drawback is offset by the fact that they provide a steady, predictable income at low risk. They may be compared to bonds in terms of risk, but offer higher returns.
Core Plus Assets
Core Plus Assets are similar to core assets, however, they offer investors the opportunity to increase profits through improving management, raising tenant quality, or making light to moderate renovations.
Risk is a bit higher, though still fairly low, however, investors should expect to be more involved in the property. In addition, although the cash flow will be higher – returns should be between 9% – 13% – some of the cash will need to be reinvested in the property.
Value Add Investments
Value-add properties are moderate to high-risk properties that offer higher profit potential than the previous two asset types.
Annual returns are generally between 13%-18%, however, properties initially have little to no cash flow, and require substantial funds in order to make sure the property fulfills its potential. Properties may need extensive renovations, management may need to be replaced, and there is usually a high vacancy rate and/or low-quality tenants.
These types of properties are considered high risk and are only for the most experienced of investors. These assets may be raw land, completely vacant, or need renovation from the ground up.
Not only do these high-risk properties require even greater work than value-add investments, but investors typically won’t see returns until three to five years. At the same time, the investor will still need to find the funds to renovate the property, while juggling no cash flow, high leverage, less favorable financing terms, and high interest rates.
On the other hand, investors who successfully turn these properties into profitable assets can make a 20% or more return on their investment.
Creating a diverse real estate portfolio, made up of assets associated with different levels of risk, allows you to balance dependable, lower risk, low-maintenance properties that offer lower returns with high risk, more demanding properties that promise higher returns.
Diversification According to the Amount Of Management Required
Another option that may be combined with any of the above diversification methods is to purchase properties that require varying levels of management commitment.
This is especially important if you have substantial commercial real estate holdings, yet still, work at a day job, or are retired and would rather enjoy your retirement.
You can do this easily by choosing a variety of net leased properties, each of which offers a different level of responsibility.
Single net properties, for example, require tenants pay only for property taxes. As the owner, you would still be responsible for taking care of all repairs, expenses, and management needed for the property.
Double net properties are similar, except in addition to property taxes, tenants are also responsible for insurance premiums as well.
Triple net lease properties require the tenant to pay nearly all expenses and often require the tenant to pay capital expenditures as well. They require no management and are thus the easiest to hold while offering steady returns.
You can find commercial properties in nearly all of commercial real estate categories (except multifamily)- office, retail, and industrial – which means you can mix and match the level of risk and responsibility according to your investment goals.