Portfolio Diversification through Real Estate (Part 3)

Introduction

Many investors look to traditional stock and bond portfolios to fund their retirement lifestyles, following a variety of methods to determine their ideal balance. Strictly sticking to traditional investments has its downfalls, though, including idiosyncratic risk and high volatility. Modern real estate investing, on the other hand, helps investors avoid pitfalls of conventional strategy and exploit areas of improvement beyond what these portfolios can offer. By mitigating risks such as volatility and inflation, investors stand to benefit from portfolio diversification via real estate.

Portfolio Diversification

Regardless of one’s risk tolerance and asset allocation, EquityMultiple recommends diversifying away from idiosyncratic risks within asset classes. Idiosyncratic risks are unique to a particular security. In the case of stocks, this can include company-specific risk, sector risk, and regulatory risk as opposed to broader market risks that may affect equities. 

Idiosyncratic risk is often unpredictable and can add undesired volatility to a portfolio, disrupting intentional risk/return goals. Diversification, however, mitigates this risk. As a result, returns within individual asset classes tend to normalize, ensuring that investors’ portfolio performances align with their chosen asset allocation strategies. 

Investors may also diversify away some of the systematic risk associated with stocks and bonds by investing into private-market real estate or other illiquid alternative assets.

Diversification Through Real Estate

Real estate investments are less susceptible to systematic risk than public equities. Especially in value-add and opportunistic investments, they tend to offer higher idiosyncratic risk than capital-market stock and bond assets. Once an investor is satisfied with the risk/return profile of their real estate allocation on a broad level, selecting diverse investments is crucial to maintaining the health of a portfolio and limiting unpredictable, idiosyncratic risk. 

In the past, the inaccessibility and inefficiency of commercial real estate investing made diversification difficult. Thus, individual investment selection was of higher consequence. With a platform like EquityMultiple, modern real estate investors can now take advantage of reduced minimums, tech-driven efficiencies, and passive ownership. They can also diversify away risk associated with individual properties.

In the world of real estate, risks can affect CRE as an asset class, specific asset types, geographic markets, as well as individual properties and sponsors. For instance, COVID-19 affected demand for real estate used for hospitality and office space, while demand for multifamily apartments remained resilient. Natural disasters may disrupt commercial real estate in select geographic markets, like Hurricane Harvey did in Houston in 2017. Changing demographics, leasing considerations, and fluctuating operating costs may also affect individual properties uniquely. Investors diversified across factors such as asset type, geography, and individual properties may reduce risk in their portfolio and achieve returns in line with their target risk/return profiles. 

The Bottom Line

Diversification is a critical component of a healthy investment portfolio as a hedge against risk, volatility, and inflation. Illiquid, alternative investments are a great way to diversify, and commercial real estate offers a number of benefits to investors. The asset class’ lack of correlation to the stock market and low volatility makes it a highly valuable tool for diversification, and the low minimums offered at EquityMultiple allow for diversification even within real estate investments.

Download the whitepaper to learn more.