Diversification is an important consideration when making direct investments in real estate. By investing in multiple properties across different geographic locations and property types, investors can reduce their exposure to local real estate market risks. A properly diversified real estate portfolio should aim to balance cash flows, leverage, and liquidity. There are several key factors that impact diversification of direct real estate investments.
Diversify across locations to reduce correlated risks
One of the main reasons to diversify real estate investments geographically is to reduce risks from correlated local market factors. Investing in only one city or region exposes the investor to greater vulnerability from local economic shifts, changes in demographics, natural disasters etc. By investing in properties across multiple cities, states or even countries, investors can mitigate these location-specific risks. For example, global gateway cities like New York, London, Singapore etc attract investment from across the world, reducing reliance on local demand-supply dynamics alone.
Balance property types to manage cash flows
Within a city or region, diversifying across property types (office, retail, multifamily etc) can also be useful from a cash flow perspective. Some property sectors like hospitality and retail tend to have greater volatility than others. Balancing more stable property types with higher growth but variable income properties can smooth overall cash flows for the real estate portfolio.
Manage leverage across properties
The amount of leverage used can vary significantly across properties based on factors like location, age, tenant profiles etc. Hence it is important to analyze leverage at individual property as well as overall portfolio level. If some properties have excessive leverage, it may hamper the ability to raise financing for other assets or force sales at sub-optimal prices in times of market dislocations.
Consider liquidity needs for each property
Liquidity refers to the ability to sell a property at fair market value within a reasonable timeframe. Investors should evaluate their liquidity needs at single property as well as overall portfolio level based on factors like planned holding periods, potential for unexpected cash needs etc. Illiquid assets like land may lock up capital for extended periods and require higher targeted returns.
In summary, diversification of direct real estate investments requires analysis across location, property type, financing strategies and liquidity planning. A balanced mix is necessary to mitigate risk and ensure stable cash flows.