The most common way to start investing in real estate is through owning a rental property to produce a steady stream of rental income. Some real estate investors think that a single rental property is enough to keep them financially secure, but this is not always true. Aiming to have a diversified real estate investment portfolio is always the better strategy in real estate investing.
About Diversification and Real Estate Investing
By diversification, we mean to distribute your capital and invest in different types of real estate properties and different housing markets. This might not be your first concern as a new real estate investor buying your first rental property. Nonetheless, it’s something that you should work towards achieving throughout your real estate investing career. How come?
The main benefit of having a diversified investment portfolio is to reduce the risks associated with one type of investment property or real estate market. The phrase “don’t put all your eggs in one basket” perfectly explains this concept, as spreading investment capital across a broad spectrum is how property investors balance risk and reward in their investment portfolio.
For example, say you own a number of investment properties in different housing markets. If something negative were to affect one type of property, it probably won’t affect other types. Similarly, if an economic event were to negatively affect one market, this will only affect a fraction of your investment instead of losing your entire investment. Thus, you’ll have a better shot to succeed in real estate investing with a diversified investment portfolio.
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So, now the question is: how can a real estate investor build a diversified investment portfolio?
1) Invest in Multi-Family Properties
While beginner property investors are advised to start out with single-family homes, they should always keep multi-family homes in mind when they’re thinking of growing their investment portfolio. These rental properties are more attractive to tenants, are easier to manage because units are clustered together, and they reduce certain risks which make them our first option for diversification in real estate investing, most importantly:
Risk of Vacancy
A vacancy occurs when the real estate investor is unable to find a tenant to occupy his/her rental property. A vacant property is a nightmare because it leads to a loss in the rental income which investors typically use to pay down their mortgage, insurance, taxes, and other rental expenses. Since multi-family properties consist of more than one unit housing a number of tenants, facing a vacancy won’t have a major effect on the rental income as it would with single-family homes – especially when investing in a real estate market with a high demand for these investment properties.
Risk of Negative Cash Flow
Negative cash flow occurs when the rental income can’t cover the rental expenses associated with real estate investing. This could happen for many reasons, one of which is facing vacancies. When you’re investing in a single-family home and your tenant gets evicted, you basically have to rely on your pocket money to cover rental expenses since the property is not generating any rental income. On the other hand, if one tenant were to be evicted from a multi-family home or move out, you’ll still be able to enjoy cash flow from the rent collected from the rest of your tenants.
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2) Invest in Commercial Real Estate
Another way to be a diverse real estate investor is to switch from residential to commercial real estate investing. Making this jump might seem overwhelming for a real estate investor, but it’s an incredibly lucrative career choice. Commercial properties can be a great source for tax breaks, a retirement strategy, or paying mortgages on your other investment properties. Other perks of investing in commercial real estate include:
Higher Return on Investment
In general, commercial properties yield a higher return on investment than residential properties. The average ROI for commercial real estate is 6-12% while the average ROI for residential real estate is 1-4%. Moreover, thanks to the “Triple Net Lease”, tenants pay for the commercial property’s taxes, property insurance, and maintenances costs in addition to the monthly rent. Therefore, property investors have the chance to make more money in real estate investing, regardless of the high start-up costs.
Another benefit of commercial properties is the fact that there is less competition for them among property investors. The average real estate investor thinks of these investment properties as complicated or outside of his/her comfort zone. For smart and successful property investors, on the other hand, this lack of competition provides an opportunity to diversify their investment portfolio and increase their financial wealth.
3) Invest in REITs
If you already own a rental property and you think you can’t handle managing another one, real estate investment trusts are a great way for you to grow and diversify your investment portfolio. These are companies that own or finance income-producing real estate properties. Benefits of investing in REITs include:
No Direct Property Ownership
A real estate investment trust will only require you to invest your capital and it will handle managing the properties. So you don’t have to worry about extra rental expenses, handling repairs and maintenance, or dealing with more tenants. If you’re looking for other ways to make money without property ownership, read this: 4 Simple Ways to Invest in Real Estate Without Buying Investment Property.
In return for your investment capital, REITs will provide you with a steady stream of passive income that comes in the form of dividends. This is great as not only will you have time to focus on your own rental property, but you’ll have an extra source of income! As you can see, REITs is a great option for real estate investing if you wish to diversify your investment portfolio but don’t have the capital or you aren’t interested in owning multiple investment properties.
Diversification and Real Estate Investing – Conclusion
There is no way set in stone to go about building a diversified real estate investment portfolio. The real estate investing business is vast and filled with opportunities that you need to analyze to determine whether or not they’ll be a good addition to your portfolio.
Keep in mind, however, that more assets or properties do NOT always mean a diversified portfolio! To reduce your risks in real estate investing, don’t invest in too many similar assets. Instead, focus on finding different investment opportunities across different locations to truly have a diverse portfolio.
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