We acquire high-quality, income-producing assets at discounts to replacement costs.
Once issues are addressed, we have the option of selling or holding for the long term.
There are several ways to diversify into real estate in the private market, each of which requires different amounts of time commitments, expertise, and money. Broadly speaking, real estate investing breaks down into two categories: active and passive.
Active real estate investing for individuals includes rental properties and house-flipping. Return potential for each of these options is limited to rental income and appreciation. These methods typically require a significant amount of personal knowledge of real estate, and hands-on management or delegation to experts, who can come with hefty fees. Additionally, large upfront capital commitments are required for the lifetime of the investment.
For example, if you buy a rental property, any money that goes toward buying the home in the form of a down payment or mortgage payment will be tied up in the property for the duration of the lifetime of the investment. Only upon selling can you access your principal and any appreciation that you’ve earned.
House-flipping is typically completed in a shorter timeframe than a rental property, typically a long-term buy-and-hold strategy, but it also usually comes with a lot more responsibility and risk. It requires an investor to add value to the home at a given budget in order to be able to sell it at a profit within a given timeframe. Any missteps can reduce or even eliminate return potential.
Because active investments typically require large capital commitments potentially for long periods of time, it’s usually difficult for investors to diversify within the asset class by investing in multiple active investments at once. By investing in only one or a few active investments, risk among those few investments is concentrated. Active investments are subject to the same market and asset class risks. And because investors typically invest locally, they’re subject to the same geographic risk.
For example, if a rental property requires unexpected repairs, or sits empty for several months at a time, as the only one or one of the few active investments held by the investor, the investor will suffer a large loss. And as the sole owner of the investment, he will bear the loss entirely.
Passive private market real estate investments are closer to what’s found in public market investments. As in the stock market, passive real estate investors typically provide only capital and allow professionals to invest in the real estate on their behalf, and passive investors bear responsibility only for their investments. Passive investments usually offer investors a portfolio of real estate, which offers greater diversification potential than active investments in a handful of properties. And unlike active investments, which earn returns primarily through rental income and appreciation only, passive investments can also earn returns through interest payments on debt investments. On top of these benefits, some passive investment options carry lower investment minimums, which offers greater accessibility to investors of all sizes.
All investment portfolios are likely to hold investments that will experience some periods of ups and downs. However, by diversifying your portfolio you can mitigate those losses, which can boost your portfolio’s return potential. But not all diversification strategies are equal, which makes choosing the right diversification strategy crucial to your success.
Most investors understand that risk comes along with investing in a single stock, asset type, or industry. But what about the risk that comes along with investing in only one market? Many investors are diversified across asset classes, sectors and industries, usually all within the stock market, which is a public market. With the public market shrinking, and ownership of stocks becoming more challenging, investments in the stock market are becoming increasingly correlated. With this, diversification is getting increasingly difficult to achieve in the public market.
Wider accessibility to private market investments offers individual investors new options outside of the stock market. Private market real estate, in particular, is far more accessible now than it has ever been. Easy accessibility, together with the benefits of low correlation with the stock market, a history of long-term appreciation, and the potential for regular income, can make real estate a powerful diversifier for your portfolio.
1) What Makes an Investment Portfolio Diversified?
Diversification is used to reduce the risk of loss, which ultimately can improve the stability and return potential of an investment portfolio. When risk is reduced properly though diversification, its volatility is reduced. With lower volatility, an investment portfolio is more stable, and its return earning potential more predictable. Rather than being forced to ride the waves of market cycles, investors are able to enjoy the peace of mind that comes with having their investments live on quieter times.
2) What does a diversified portfolio look like?
There are many diversification strategies to choose from, but strong ones generally try to maximize a portfolio’s risk-adjusted returns. In other words, you should try to invest in assets that offer the highest possible return at your given risk level. By investing in assets with low or no correlation, you can reduce unnecessary risk in your portfolio.
When investments are correlated, they share some or all of the same set of risks. So, if one investment experiences a loss, then a correlated investment is also at risk of loss. On the other hand, if your portfolio holdings are spread across uncorrelated assets, the performance of one or more investment could mitigate losses in your portfolio when another asset underperforms. This is because uncorrelated assets are far less likely to lose value in tandem than correlated investments.
3) Markets with Low Correlation
The biggest difference between private market real estate and traditional public investments is the fact that they are traded in different markets. Traditional investments, such as stocks, bonds, and mutual funds are traded on a public exchange, such as the stock market, whereas private market real estate trades in the private market. Public market investments have their own sets of advantages and disadvantages, but because they’re traded in the same market, their performance is correlated, because they share the same market wide strengths and weaknesses. On the other hand, because private market investments are traded in a separate market, which is subject to a different set of driving forces and structural features, they don’t share the same sets of risks as public investments. Therefore, private market real estate has a low correlation with traditional publicly traded investments at the market level.
For instance, expectations of future interest rate hikes (or actual hikes) typically cause the stock market to decline, because higher interest rates make credit and loans more expensive, which can reduce both business and consumer spending.
By contrast, expected or actual shifts in the interest rate environment should have minimal impact on an investor’s equity stake in a private commercial real estate investment. In fact, an interest rate hike could make the asset more valuable, because it now offers an interest rate hedge, and stands to benefit from the likely positive macroeconomic market conditions that typically precede federal interest rate hikes.
4) The 20% Rule
The 20% rule is a leading diversification strategy, which was created by the Chief Investment Officer of the Yale Endowment, David Swensen. The 20% rule aims to reduce portfolio risk and in turn maximize return potential by allocating at least 20% of an investment portfolio toward alternatives – an asset class with low or no correlation with traditional, publicly-traded assets. Alternative investments are investments that fall outside of the classification of traditional investments and are generally traded in the private market. Following the 20% rule, private market investments are becoming increasingly crucial to investment success. Institutional investors have a longer history of diversifying into alternative investments with pensions and endowments allocating 28% and 52% of their portfolios respectively to alternatives.