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Leveraging Diversification To Enhance Real Estate Risk-Adjusted Returns

Feb 8, 2017

In a previous article (How To Diversify Like A Property Expert”) we looked at what diversification is and why it is so important for profitable real estate investment. In this article we’ll be taking a more in-depth look at how diversification applies to property investment and the building of a strong property portfolio.

The overall aim of any diversification strategy is to minimise risk and increase the chances of strong returns. To do this there are a number of factors that real estate investors need to take into account:

 

Property type

The first thing you’ll need to consider is what type of properties you want to invest in. Generally speaking, you will be faced with a choice of commercial or residential, but there are sub-categories in each of these that you need to know about. Residential, for instance, has a number of different options to consider: luxury vs. non-luxury, apartments vs. detached housing, holiday lets, rental properties, etc. With commercial property you’ll have to think about everything from offices, to shopping malls, to industrial buildings. Each property type has its merits, of course – luxury residential property, for example, has the benefit of exclusivity, which helps defend against fluctuations in the market; non-luxury real estate, on the other hand, is cheaper and more readily available. The key is to strike a balance between each type and provide enough variation to lower the overall risk profile of your portfolio

 

Property location

Where the properties are located can make all the difference in terms of gaining good returns. Investors will need to study the market closely and assess which cities/countries have strong property markets and which do not, and then invest accordingly. It is always advisable to find real estate in locations that are already desirable and still gaining popularity; there are a number of indicators you can look out for that will help determine if a location is increasing in terms of desirability: rise in development, increased tourism statistics, opening of new attractions (restaurants, hotels, museums etc.), construction of better transport links. Miami, for example, welcomed 14.6 million visitors in 2014, an all-time record for the city’s tourism. Again, the key here is variation: always aim to invest in more than one location.

 

Investment strategy

Strategies for real estate investment can be broadly broken down into 4 main categories:

  • Core – A low-risk strategy that focuses on established properties in profitable areas, aiming for predictable cash-flow.
  • Core Plus – similar to core, but including properties that need some enhancement. Higher risks are balanced by the potential for better returns.
  • Value Added – a strategy that involves buying properties that are in need of improvement and selling them at opportune moments.
  • Opportunistic – a high-risk, high-return approach in which properties in need of vast amounts of improvement are invested in for tactical reasons.

Which of these approaches you choose depends on what your desired outcomes are, but the core and core plus strategies represent the most risk-averse options, making them the best choices for diversification.

 

Investment horizon

Investors will also need to consider what kind of timescale they want to operate on. Long-term strategies stretched over a number of years tend to work best for portfolio diversification due to the fact that long-term investment has a lower risk profile than short-term investment. Investing on the basis of years rather than months means you can choose safer properties with slightly lower return percentages, allowing enough time for the returns to accumulate steadily over the years. This is a far more secure approach than going for the quick fix-and-flip options, which are highly risky and rely too heavily on immediate returns (which rarely happen in the investment market).

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