Diversification from the traditional Wall Street sense is meant to minimize risk. The idea is to spread assets across a variety of companies so that the other assets offset downturns in any one company in the portfolio.
But what happens when the entire market nosedives like with the recent stock market plunge from the COVID-19 economic upheaval?
Stock market diversification in downturns won’t save any portfolios. The idea of not putting all your eggs in one basket is fine and dandy in a stable market. Still, if all the baskets are in a building that burns to the ground like in a stock market crash, diversification in public equities is useless.
With volatility in the stock market, many investors turn to alternative assets to insulate their portfolios from uncertainty in the broader markets.
One of the most popular alternative asset classes investors turn to is commercial real estate for cash flow and the security of being backed by a tangible asset.
If you’re one of these investors turning to commercial real estate (CRE), be sure to avoid the diversification mistakes of public equity investors who diversify for the sake of diversifying. Their portfolios become a jumble of companies with no connection that may minimize risk but, at the same time, minimize returns.
Novice investors in commercial real estate make this same diversification mistake: They’ll take stakes in every asset class – office, professional, retail, hospitality, multifamily – without thoroughly assessing the market.
It’s important to note that while commercial real estate has a low correlation to Wall Street as a whole, certain asset classes dip in a downturn like the one we’re experiencing right now. That’s why it’s important not to get carried away with diversifying for diversification’s sake.
With the lockdown environment we’re all living in right now; there are certain classes of CRE poised to suffer in the next year.
To that point, do not diversify with the following assets in the next year:
Obviously, with stay-at-home orders and factories and offices shut down, people traveling and shopping onsite less and working from home more, the demand for all those listed classes of CRE is expected to plummet.
That’s why a broad diversification strategy is not advisable in the next year.
You’re thinking, “All I’m left with is multifamily to consider for investment in the next year. I don’t want to put all my eggs in one basket.” Take heart.
Warren Buffett doesn’t think broad diversification is all it’s cracked up to be anyway, so don’t worry that all you’re relegated to is multifamily.
– Warren Buffett
Concentration – as Warren Buffet puts it – in a single asset class like multifamily that cash flows and thrive in a downturn are ideal for building wealth.
For those who can’t shake the diversification itch, there’s good news:
Commercial real estate lends itself to a variety of diversification strategies for spreading the risk. So, even if you’re concentrated in a single asset class such as multifamily, there are ways to diversify if you want to avoid “putting all your eggs in one basket.”
Sophisticated investors who invest in multifamily, invest passively through private investment vehicles.
Private investments allow sophisticated investors to leverage the expertise of others and offer the opportunity to diversify in more ways than just owning stock in more than one company like in the public markets.
In the private sector, diversification can be accomplished within a concentrated asset class across a variety of factors, including:
- Stage of Development
- Security Type
- Type of Return
- Holding Period
- Risk-Return Profile
- Geographic Location
An equity investment in a core multifamily property in a gateway market with a 7-year investment window added to a portfolio with a debt investment in a value-add property in a secondary market with a 3-year window is the type of “intra-asset” diversification practiced by sophisticated investors. This meets both the “concentration” strategy advised by Warren Buffett while providing diversification.
In the next year, resist the urge to diversify with hospitality, office, retail, and professional CRE assets.
The one asset class poised to thrive in the next year is multifamily.
Don’t fret that it’s a single asset class because sophisticated investors have been using an “intra-asset diversification” strategy to diversify risk without compromising returns for decades.
Investors invested in multifamily assets across a variety of development stages, security types, types of return, risk-return profiles, holding periods, and geographic location, investors can build wealth while achieving diversification.
Kyle Jones is a co-founder and Key Principal of TruePoint Capital, LLC. Kyle is responsible for the company’s strategic planning, investment decisions, asset management, and overseeing all aspects of the company’s financial activities, operations, and investor relations.
Kyle obtained a Bachelor of Science degree from Texas State University – San Marcos, where he also played Division 1 Baseball.