Savvy investors and financial experts know how crucial portfolio diversification is. This simple act can help mitigate risk and reduce the chance of significant financial losses. But, if you participate in commercial real estate investing, you may be surprised to learn that diversifying commercial real estate investments themselves is just as critical.
Nonetheless, there are several ways to diversify a commercial real estate portfolio. Some conventional ways to diversify a commercial real estate portfolio are geographic location, asset class, and property type. We’ll explain each of these commercial real estate diversification strategies below. Let’s read on.
Why Diversifying Commercial Real Estate Investments Is Crucial
You may have heard the phrase, “don’t put all your eggs in one basket.” This statement’s meaning applies to commercial real estate investing and finance and why diversifying commercial real estate investments is crucial. Think about what happens to a single stock over a year or two. You will likely notice fluctuations in its share price.
Say you invested 100% of your retirement savings in a single stock. This exposes you to increased risk and vulnerability in multiple ways. If that stock’s share price tanks, so does your retirement portfolio. Essentially, you’re betting all your money on the financial performance of one company.
Undoubtedly, some companies or stocks will perform well no matter what. However, most will go up and down. Investing in more than one company or stock and diversifying commercial real estate investments ensure your portfolio’s value balances out. One tanking stock may not impact your retirement savings much if you have significant gains in other investments.
In the same way, different commercial real estate properties can produce various returns depending on location, condition, and property type.
Ways to Diversify Your Commercial Real Estate Investing
Diversifying commercial real estate investments is simple if you think about the main differences between properties. Commercial real estate investing is about building a portfolio based on the following factors:
- Geographic location
- Asset class
- Property type
A balanced commercial real estate portfolio includes various properties that represent different locations, various asset classes, or diverse property types. Of course, you could choose to invest in commercial real estate that represents a combination of all three means of diversification.
Let’s look at what each of these factors means, such as geographic area, property condition, and type.
Diversifying commercial real estate investments could be as simple as choosing properties in various locations. For example, you might have properties in urban cities, suburbs, and rural or remote towns. Each of these locations comes with risk factors and benefits.
Urban cities will usually draw more foot traffic, higher rental rates, and larger resale or market values. Suburbs can be the middle of the road when it comes to rental rates and market values. However, these properties may produce a larger return over time due to higher growth rates. Rural or remote towns may not have the highest values but could offer stability.
In commercial real estate investing, asset class usually refers to a property’s age and condition. For example, Class A properties are typically newer and don’t need much work or maintenance. A Class B property is somewhat aged; usually between 10 and 20 years. These properties may not be prime real estate, but they’re still in decent locations and don’t require major renovations.
A Class C property is older than 20 years and may need some updating and rehab work. There is still the potential for returns and growth with Class C properties. At the bottom of the spectrum are Class D investments, which are distressed properties. These need significant work and carry the most risk.
This may be the easiest commercial real estate diversification strategy to understand. A commercial real estate portfolio can contain office buildings, strip malls with outparcels, shopping centers, industrial complexes, and multifamily buildings or apartments/townhomes.
The last property type may be somewhat surprising, but insurance companies classify multifamily dwellings as commercial properties. Yet another type of commercial real estate investment is a commercial real estate investment trust or REIT.
These are similar to mutual funds as you own a percentage of various properties and a fund manager buys them on your behalf. However, the fund manager also oversees your investment risk and diversifies your commercial real estate portfolio for you.
Diversifying Your Commercial Real Estate Investments via Multiple Strategies
As a commercial real estate investor, you may want to use more sophisticated diversification strategies. Say you’re just starting and want to concentrate on buying properties in one state or a few states in the same region. This will limit your ability to rely on geographic location as a diversification strategy.
Even so, your commercial real estate investing efforts can still use some location diversification. For example, you could buy an office building in Atlanta and a commercial strip mall in Orlando, Florida. Later on, your commercial real estate portfolio could include a new multifamily dwelling in the Atlanta suburbs.
Another multi-strategic approach could include a distressed property in the middle of downtown Atlanta and a new strip mall with office space in a suburban city 60 miles from Atlanta’s center. As investors start acquiring more properties, they may organically fall into a pattern that relies on multiple diversification strategies.
On the other hand, some commercial real estate investors prefer to focus on a specific property type, asset class, or location. In these cases, diversifying commercial real estate investments might include focusing on one of the other factors or strategies.
Examples of Focused Diversification Strategies
Say you want to only buy multifamily dwellings for commercial real estate investing. Although this will increase your exposure to risks associated with this property type, this will still help you in diversifying commercial real estate investments. A REIT is one example. In a REIT, you can tell the fund manager to choose apartments and townhomes across the country.
You’re still diversifying because you’re investing in multifamily dwellings in various real estate markets.
If property values start dropping in New York but increase in Los Angeles, your risk of losing money decreases. Diversifying commercial real estate investments is still possible as long as you increase the number of locations or asset classes. Another way to diversify commercial real estate investments in multifamily dwellings is through property age or condition.
You can buy some apartment buildings that are less than 10 years old, a few others that are slightly older, and some retro buildings. Beginners or investors who are risk-averse will probably want to steer clear of Class D or distressed properties. But by mixing up the asset class, you can achieve some diversification and mitigate unique asset class risks.
You’ll likely spend less on your Class A properties and get a steady flow of tenants. For your Class B assets, you’ll invest a bit more and may see less stability in tenants. However, you could potentially reap higher rewards when selling these properties. A similar situation will exist with any Class C assets, but the stakes and variability will be higher.
If any of these strategies interest you, at EXtrance, we provide a platform to help diversify your portfolio in commercial real estate investing.
Balancing Your Commercial Real Estate Portfolio
Diversifying commercial real estate investments isn’t too difficult if you remember not to become too concentrated on one factor. For example, you don’t want to just invest in a bunch of new office buildings in the same area. That said, you may find it more practical or feasible to have some focus.
You may not want to buy strip malls all over the country if you’re running your commercial real estate or property management business. Instead, you can diversify your commercial real estate investing efforts by purchasing strip malls in different nearby cities. For example, you could buy a center in Jacksonville, Florida, and another one in Tampa.
Even though both of these centers are in Florida, Jacksonville and Tampa represent different real estate markets. One may experience more seasonal tourism while the other mostly caters to locals. As time goes on, you might also find you need to rebalance your portfolio. A critical part of diversification in commercial real estate investing is reevaluating the mix of properties you have.
Using the above example, you might decide to sell the strip mall in Jacksonville once it’s 10 years old. In its place, you buy a new center in Miami with more high-profile tenants. And you decide to hold onto the Tampa property for the time being.
You may also consider limited partnerships to diversify commercial real estate investments. Under our solicitation system, you can connect and partner up with other investors for commercial real estate, providing you with more real estate investment opportunities.
Commercial real estate investing may involve more money and risk than stocks and bonds. However, commercial real estate requires diversification just like other types of portfolios. You don’t want to overinvest in a single type of property, location radius, or asset class.
At EXtrance, we provide a platform for connecting limited partners with general partner to maximize investment opportunity, speed up liquidity, and gain transparency on investments. This is where you can digest all the information in uncomplicated ways and decide your best option for investing.
Diversifying commercial real estate investments involves varying locations, asset classes, and property types. Contact EXtrance today, so we can help you enhance your current commercial real estate investments.