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How to Enhance Portfolio Diversification Using Real Estate

All investment portfolios – even the strongest – are likely to hold
investments that will experience some periods of loss. However, by
diversifying your portfolio holdings, you can mitigate those losses,
which can boost your portfolio’s return potential. But not all
diversification strategies are created equal, which makes choosing the
right diversification strategy crucial to your investment success.

Most investors understand the risk that comes with investing in a single
stock, asset type, or industry. But what about the risk that comes with
investing in only one market? Many investors are diversified across and
within asset classes, sectors, industries, and more – but, usually all
within the stock market, which is a public market. With the public
market shrinking, and ownership of stocks becoming more consolidated,
investments traded in the stock market are becoming increasingly
correlated. With this, meaningful diversification is getting
increasingly difficult to achieve in the public market alone.

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.

Jump to
What Make an Investment Portfolio Diversified?
The 20% Rule
How Real Estate Can Enhance Portfolio Diversification
How to Diversify into Private Market Real Estate
Evaluating Your Options
What Make 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 waters.

So, 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.

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 with pensions and endowments
allocating 28% and 52% of their portfolios respectively to alternatives.

investment-portfolio diversification-20-percent-rule

How Real Estate Can Enhance Portfolio Diversification
The private market experiences very different buying and selling
dynamics than the public market. Let’s look at the attributes of private
market real estate and how this asset class can be a powerful
complementary diversifier for a portfolio of traditional investments.

Separate Markets with Low Correlation
The biggest difference between private market real estate and
traditional investments is that they trade in different markets.
Traditional investments, such as stocks, bonds, and commodities, trade
in the stock market, whereas private market real estate trades in, as
you may guess, the private market. Public market investments each have
their own individual sets of advantages and disadvantages, but because
they’re traded in the same market, they share the same marketwide
strengths and weaknesses. And, because private market investments are
traded in a separate market subject to different driving forces and
structural features, they don’t share the same wide risks as public
investments. Therefore, private market real estate has a low correlation
with traditional 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 can reduce both business and consumer spending.
Similarly, expected or actual rate hikes can have a depressing effect on
publicly traded real estate investment trust (REIT) share valuations,
because higher interest rates reduce the risk-free to capitalization
rate spread thereby driving down real estate values.

By contrast, expected or actual shifts in the interest rate environment
should have minimal impact on an investor’s equity stake in a commercial
real estate asset as long as the senior debt financing secured for that
investment is a long-term loan with a fixed-rate. 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.

Distinctive Investment Structures by Market
Coupled with low correlation at the market level, the performance of
private market real estate has a low correlation with the performance of
public market investments at the asset class level. Although real estate
is traded in the public market through REITs, private market real estate
investments are structured in a wholly different manner. REITs
themselves are structured differently in the private market, whether
private REITs or public non-traded REITs, which gives REITs different
diversification potential based on the market in which they’re traded.

In general, these different structures carry different sets of risks,
fee structures, return structures, and varying return potential.
Therefore the differences in investment structures between public and
private market vehicles further reduce the correlation between private
market real estate and traditional investments.

Differences in Access to Liquidity
One of the biggest benefits of public market investments is the high
level of liquidity that they offer. Shares of stocks and bonds can
easily be bought and sold on a daily basis. Because of this, public
market investments offer a high degree of flexibility.

However, it’s important to note that this access to daily liquidity
comes at a price. The liquidity premium is a built-in cost, which is
innate to public market investments. Investors pay whenever they buy an
investment. For long-term investors who follow the “buy-and-hold”
strategy, this can be an expensive feature that goes largely unused.
Those who are building a portfolio to support their retirement plan are
usually long-term investors, who should likely lean more toward
long-term investments. Avoiding costly features that go mostly unused
while building the most stable and reliable path to retirements saving
possible are key.

Private market real estate, on the other hand, is generally illiquid
with return potential maximized over time through rental income and/or
appreciation. Liquidity options for both public and private investments
each have their advantages and disadvantages, but their differences can
make private market real estate a good fit for long-term investors, as
well as powerful complementary diversifiers for investments with shorter
investment horizons.

Market Efficiency Mean a Lot for Investors
The public market is highly efficient with prices set by the market.
Information concerning public investments is widely disseminated, which
makes it difficult for one party to gain more information than the other
party on an investment. Transaction costs are also low, which results in
more frequent buying and selling. In fact, more than a billion shares
are publicly traded each trading day.

In contrast, the private market is highly inefficient. Buying and
selling private market real estate generally comes with higher
transaction costs, and with fewer buyers and sellers participating.
These differences in buying and selling dynamics in the private market
offer another diversifying element for investors largely invested in the
public market.

While these conditions may seem unfavorable, they are actually
potentially more favorable to investors. That’s because whereas the
market sets prices in the efficient public market, there’s room for
negotiation between the buyer and seller in the inefficient private
market. With fewer buyers and seller participating in the market, and
with information unequally shared, the market doesn’t necessarily set
the price of the asset, giving investors a greater chance to “beat the
market” in a way that isn’t possible to do on a consistent basis in the
public market.

Essentially, limited competition on the buyer’s side in private markets
gives those with the necessary knowledge, skills, and resources a
competitive advantage to earn above-market returns, or alpha. An
investor who holds common stock in a publicly-traded company doesn’t
have the ability to earn outsized returns because they have more
knowledge, resources or skills than another common-stock holder. An
investor could spend hours daily researching Apple, but this would
likely not change their return potential from their Apple shares. In
other words, your returns will be the same as those earned by any other
shareholder with the same class of stock who buys and sells those shares
at the same time.

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How to Diversify into Private Market Real Estate
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 Investing
Active real estate investing for individuals includes options, such as
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.

Diversification 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 Investing
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 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.

Private Equity Fund

A private equity fund is an investment model where investors pool their
money together into a single fund to make investments. A designated
manager or management group usually manages the operations of the fund,
while investors aren’t required to participate on a daily basis. Real
estate-oriented private equity funds typically hold multiple real estate
investments at once, but volume depends on the dollar size of each
investment as well as the investment capacity of the fund.

Due to the fact that the investment capacity of each private equity fund
is different, each one offers different diversification potential within
the asset class of real estate. In order to invest wisely and to
understand how these investments can impact the risk and return
potential of their portfolios.

Access to private equity funds is generally limited to accredited and
institutional investors with high net worths. Investment minimums can
vary, but are usually not less than $100,000. These investments are also
generally illiquid. Additionally, private equity funds typically use a
“two and twenty” model, in which they charge a 2% annual management fee
and an additional 20% fee on any profits that the fund earns. Due to the
high investment minimums and fees entailed in private equity investing,
it is important for investors to have the financial and real estate
knowledge necessary to understand the risks and potential value of each
investment.

Private REITs

Like public REITs, a private REIT typically offers a wide portfolio of
real estate investments. By law, a REIT must earn at least 75% of its
gross income from real estate and invest at least 75% of its assets in
real estate. Additionally, it must distribute at least 90% of its
taxable income to shareholders each year.

Private REITs are similar to private equity funds in many ways. They are
usually limited to accredited investors, and while minimums are
subjective, they are usually quite high. Investments are typically
illiquid, and the REIT structure also generally carries high fees,
sometimes as much as 15% in the form of upfront formation fees, ongoing
management fees and in some cases carried interest fees.

Due to the similarities with private equity funds, the diversification
potential of private REITs varies by each individual REIT. Therefore, in
order to be able to assess the risk and value of each investment held by
the REIT, and to determine the impact on an investor’s portfolio, it’s
important that investors have the required financial and real estate
knowledge before investing.

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Online Real Estate Investment Platforms

Online real estate platforms offer a new way to invest in single
investments or a diversified portfolio of real estate. Some platforms
focus on debt investments or rental properties, while others focus on
specific geographic locations. Platforms that limit real estate
investments by geography or asset class concentrate along those lines,
which inherently limits their diversification potential. Platforms that
diversify real estate investment along the lines of investment type
(debt, equity) and property type (residential and commercial), as well
as by geography, stand to offer investors stronger diversification
potential.

Investor access can also vary by platform. Some platforms are restricted
to accredited investors, and others available to non-accredited
investors can still carry high investment minimums. However, this isn’t
the case for all real estate investment platforms.

For example, Fundrise offers access to portfolios of real estate
diversified across dozens of debt and equity investments, commercial and
residential real estate, as well as geography. This provides investors
with not only exposure to private market real estate, but also critical
diversification within the asset class of private real estate,
potentially reducing risk and boosting return potential. Unlike other
restrictive real estate investments, Fundrise is open to accredited and
non-accredited investors with a low investment minimum of only $500.

Evaluating Your Options
Fundrise is the first investment platform to create a simple way for
anyone to access institutional-quality private real estate, along with
its historically consistent, exceptional earning potential, and its
diversification power.

It’s up to each investor to determine which asset classes and
diversification strategies suit them best. But, no matter how you choose
to diversify, the traditional barriers that once restricted access to
useful diversification have fortunately been lowered, giving investors
the power to construct truly diversified, risk-mitigated portfolios like
never before.

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