I learned the commercial real estate business in the 1980’s and 1990’s in Seattle from a gentleman named Frank. Out of a mostly two-person office, we handled all of William E. Boeing’s real estate – the sole living heir to the Boeing Trust and a large landowner/developer. We also handled the lion’s share of the real estate business of the seven Boeing companies located in the Greater Seattle Area at that time. It put me in the middle of some very smart real estate decision-makers. 

Bill Boeing’s right-hand man, Jack, called me almost every day. Always sharing his insights, he consistently reinforced three concepts regarding real estate investing for his boss. “Think long-term. This isn’t day trading,” he would say. “Always, ALWAYS buy good dirt, Don. And remember, diversification is your friend!”   

Diversification is your friend. 

It’s an obvious concept, but not all investors execute it equally. The following are some thoughts that may help you implement a solid diversification strategy in your real estate portfolio. 

Diversification and its benefits are conceptually easy to understand. By spreading investments across various properties and locations, investors aim to shield themselves from localized market downturns and capitalize on diverse revenue streams. However, while diversification can offer significant benefits, it is crucial to understand the nuances between beneficial diversification and detrimental dilution.

Diversification Advantages

1. Risk Mitigation

Diversification helps mitigate risk by spreading investments across different geographical areas and properties. A downturn in one market or a particular property’s performance is less likely to affect the entire portfolio. For instance, if an investor holds properties in multiple cities, a local temporary economic slump in one city will not drastically impact the portfolio’s returns.

2. Stabilized Income Streams

By investing in different multifamily assets, investors may be able to achieve more stable and predictable cash flow. If rent growth temporarily slows down in one market, it could easily be accelerating in other markets. By having exposure to multiple markets, you are more likely to reduce income volatility across your real estate portfolio.

3. Opportunities for Growth

Assets in stronger demographic markets are more likely to provide above-average income and equity growth. By holding assets in several proven markets, you increase your exposure to growth events. This approach not only spreads risk but also enhances the potential for finding high-performing assets that outperform slower-growth investments.

4. Reduced Impact of Supply/Demand Cycles

Other than the financing aspect, all real estate is local. Each market and submarket will be impacted at different times by under and over-supply of new or total rental units. A well-diversified portfolio with exposure to multiple markets will be less impacted when one or two markets deal with short-term oversupply. On the other hand, exposure to multiple markets offers more opportunities to take advantage of periods of undersupply. Ultimately, you’re able to smooth out overall portfolio performance across market conditions.

Cautions: Balancing Diversification and Dilution

While diversification can be beneficial, it is essential to differentiate it from dilution.

Dilution can occur when diversification is taken too far, leading to a portfolio so fragmented it undermines performance. Here are some key signs that could lead to an overly diversified/diluted portfolio:

1. Too many asset classes

Commercial real estate asset classes have different management and operations requirements. Some assets are highly operations intensive, like hotels. Others are relatively hands-off, like industrial projects. Across the asset spectrum, though, you will almost always get better results if you’re investing with sponsors with deep operational expertise in that specific asset class. Generalists are fine. But, you’ll make more money and sleep better at night with proven specialists. If you find your sponsor is chasing different asset classes just to get the fund allocated, and they don’t have a significant long-term proven track record with that asset class, you’re likely looking at a dilutive event for your investment.

2. Mismanaged Geographic Expansion

In an effort to bring more deals to the market, you will sometimes see a sponsor spread into markets and submarkets that seem haphazard or opportunistic. It could be perfectly appropriate, but it’s worth verifying. Fortunately, though, there are a few key tests you can apply to see if their market strategy is beneficial diversification vs. risky dilution.

• Test one: Does the new market have similar or stronger demographics than the existing portfolio assets?
• Test two: Are the growth assumptions for the new market based on long-term averages of that market or are they hoping and dependent on outsized assumptions or a new job center/entertainment complex/university project to drive performance?
• Test three: Is the new market large enough to support sufficient staff employment, access to trades, etc.? That path of growth story may be perfectly fine, but it can materially impact your portfolio’s performance if it takes two to three times longer for the path of growth to catch up to the sponsor’s new asset.

Ultimately, exposure to additional attractive markets is a good thing. Just make sure that’s the case. Not all markets are created equal.

3. Collections of small deals

Every additional project in your portfolio or in a fund’s portfolio is a different P/L, a different balance sheet, a different management team, etc. Sufficient diversification is useful, but collections of micro slices of investments can be counterproductive. The investment company’s asset management team must be of adequate size and scale to provide appropriate oversight across all these projects. If not, their diminished supervision will increase the risk of poor performance across the entire portfolio.

4. Lack of management control or partnering with too many operators

If you’re managing your own diversification by investing with multiple sponsors across multiple assets, there will be a limit to how well you can manage the portfolio collection. Each sponsor will have its own reporting process, investment strategy, market expertise, asset expertise, etc. Don’t get me wrong, some level of manager diversification is useful, but 1-2 may be sufficient if you’re working with top-quality sponsors. Over-allocating with a proven sponsor with a good long-term track record across multiple markets will be far more successful than spreading your allocation across several new/unproven sponsors.

If you’re investing with a highly diversified sponsor, make sure you’re not picking up unknown manager risk. There are generally two types of real estate investment sponsors – asset managers and asset allocators.

Asset managers have direct control over the properties they purchase and operate. They are likely the primary guarantor on the debt. They control the operations, asset management, and construction management teams. They are proven specialists. When they diversify across multiple markets, they are doing so with full operational control.

Asset allocators, on the other hand, do not have direct control. Depending on the fund investment they have made with an investment partner, they may have major decision rights, but they will not have day-to-day operational control. So you get the geographic and asset diversification without the proven expertise. And even if it’s a collection of proven sponsors the allocator invests with, they are still dealing with another level of management and fees. You generally find this structure with sponsors that are good at raising capital but don’t necessarily have the operations or market expertise within their teams to have direct control at scale. The dilution potential here is high.

Over the years, I’ve spoken with thousands of investors. Rare is the instance where an investor would not benefit from an overarching diversification strategy. This can be accomplished in multiple ways. Some investors like the built-in diversification that comes with participating in a fund. Others might prefer to create their own diversified portfolio over time by participating in multiple individual deals.

At 37th Parallel Properties, we provide two types of investment vehicles: funds and individual property vehicles. Both are blended-return investments, offering the potential for quarterly current income and long-term equity growth. You can check out our investment vehicles and 100% profitable track record here.

Remember, it is not just diversifying for the sake of diversification that is relevant. It is important with whom you diversify. In fact, the most important thing that will impact one’s success as an investor in the multifamily space is the quality of the sponsor.

• What is their approach/philosophy to the business?
• Does that approach align with the markets in which they participate?
• Does their underwriting seem conservative, or does it appear aggressively hopeful?
• Do the sponsor performance projections seem conservative, or do they feel too aggressive?
• Does their prior performance and track record enhance or detract from your confidence?
• While past performance is no guarantee of future performance, what does it indicate?
• Is the sponsor’s approach a match for what you, as an investor, are looking for?

And finally, a question for you…

How effective is your diversification strategy?

We’re here to help if you would like a quick portfolio review or have any questions about how stable income-producing multifamily can improve your investment results.

Schedule a brief introductory call today.