Should you aim for diversification in your real estate investments? What about your stock investments?
Oddly enough, many real estate investors never bother to ask that question. They just assume that all real estate investments require a lot of money and that each niche requires so much skill that you can only master one.
They’re wrong on both counts, and it adds risk to their investment portfolio.
Warren Buffett’s Take
Berkshire Hathaway CEO Warren Buffett famously said, “We think diversification is—as practiced generally—makes very little sense for anyone that knows what they’re doing…it is a protection against ignorance.”
Don’t get me wrong: I have nothing but respect for the Oracle of Omaha. He’s built an incredible career out of choosing stocks and other investments.
But guess what? You’re not the near-prescient investment analyst that Warren Buffett is, and neither am I. Most of us can’t pick winners with the consistency that he can.
That goes for professional investment managers, too, not just part-time or retail investors. It’s why actively managed mutual funds historically perform worse than passively managed ETFs.
And don’t tell me about how different real estate investing is from stock investing or how the same principles don’t apply to you. Most novice real estate investors lose thousands of dollars on their first few deals. It’s tuition to learn the ropes. Even after getting some expertise under your belt, real estate investors still end up making costly mistakes sometimes, or have market conditions fall out beneath their feet.
Real Estate Lends Itself to Narrow and Deep
Real estate is expensive. If you buy a property by yourself, you’ll likely need $50,000 to $100,000 between the down payment, closing costs, cash reserves, and possibly the initial repair costs. And if you invest passively in real estate syndications, you usually need a similar amount for the minimum investment. That makes it hard to diversify when each individual asset requires so much capital.
Likewise, active real estate investing requires niche expertise. If you invest in Section 8 properties, mobile home parks, self-storage facilities, or in any other niche for that matter, you need to master the skills and knowledge required to succeed in that niche. That, too, makes it hard to diversify—you can’t just learn a new niche overnight and expect success buying up luxury retail properties in primary markets.
Andrew Helling of Helling Homebuyers sums up the consensus argument:
“Diversification limits your ability to understand specific market niches and often causes you to miss out on opportunities that come with a concentrated investment strategy. While it’s riskier, I prefer to go all-in on local deals that I really understand. These are easier to manage, quicker to visit, and require less work, since I know the local market very well.”
You can see why real estate investors typically opt for a handful of similar properties in a few markets. In other words: narrow and deep, as opposed to wide and shallow.
Contrarian Take: Why I Go Wide and Shallow
Markets are unpredictable, and my crystal ball is no clearer than anyone else’s. In fact, every time I’ve tried to get clever with investments, the universe has served me up a big slice of humble pie.
I’ve seen real estate deals go south after all the numbers on paper looked great. I’ve seen syndicators fall apart after many people I respect recommended I invest with them. And I’ve seen white-hot housing markets collapse in value after nothing but positive buzz from pundits and investors alike.
So, I invest $5,000 in a new passive real estate investment every month as one of hundreds of members of SparkRental’s Co-Investing Club. In the last year, I’ve invested in multifamily properties, mobile home parks, retail, storage, industrial, and more—all with different syndicators and investors in different markets across the U.S. Most of the deals we review each month are real estate syndications, but some are funds or notes.
“Spreading investments amongst various property types can protect your return when certain sectors retract or underperform,” explains Ryan Martinson of WhatsMyPayment.com. “When a particular segment booms, diverse investors participate in the upside.”
Risk Mitigation Strategies
Specifically, my diversification strategy protects me from risk in the following ways.
You might scoff now, but in 2006, big real estate players from New York and Washington, D.C., were plowing huge amounts of money into Baltimore real estate. The city had a renewed sense of optimism at the time, with crime rates slowly but steadily decreasing and lots of money pouring into low-income neighborhoods.
As a Baltimore native and a naïve young real estate investor, I, too, jumped on the bandwagon. Then I got my butt handed to me in 2008.
All that outside money disappeared virtually overnight. Up-and-coming neighborhoods slipped back into decay. And a few years later, in the wake of riots, crime rates increased again.
The details differ as you look at other real estate markets around the country, but the lesson is the same: Sometimes, markets reverse course unexpectedly. I lived in San Francisco briefly in 2009 and loved it (even if it already flashed warning signs for sociopolitical issues by then). Everyone speculated on San Francisco properties for two decades—only to see values crumble over the last few years.
Austin, Texas, and Boise, Idaho, were white-hot a few years ago and then had a terrible 2023. In the ‘90s and ‘00s, people had written off Rust Belt cities in the Midwest, only to have them resurge later.
The bottom line: You can’t always predict where a market will turn next. So don’t put all your eggs in one basket.
After the Great Recession, everyone said self-storage was the ultimate risk-free real estate investment. In a recession, people downsize and need storage, right?
Until you overbuild them and the fundamentals of supply and demand catch up with you.
As an aside, it actually turns out that while self-storage isn’t very correlated with home prices or unemployment, it is heavily correlated with home sale volume. People rent storage units when they move, and in the near-record-low transaction volume of the last year, storage has suffered.
Again, I can’t predict what will happen in a specific industry or for a specific property type. To be frank, I actually just recently learned about how dependent storage is on home sale volume. But it goes to show you that even the big Wall Street institutional funds, which have poured money into storage over the past few years, often get it wrong.
And if they often get it wrong, you better believe you will sometimes, too, and probably more often.
When we first launched our Co-Investing Club, I asked a lot of experienced real estate investors, both active and passive, about the sponsors (syndicators) they recommended. I heard a lot of names, but two names kept coming up again and again. These two big names had an immaculate reputation and plenty of experience and deal volume.
Guess what? They’ve been by far the two worst-performing syndicators we invested with in our investment club. In fact, they’re the only two that have given me any cause for concern.
You can look at an investor’s track record and ask others in the industry about them. But you just can’t predict how a general partner will perform when market conditions change. And spoiler alert: They always change sooner or later.
Today, the rule of thumb we try to follow in the Co-Investing Club is a one-year “probation period” after our first investment with a sponsor. We want to see how well they communicate, how they handle hiccups, whether they start distributions on time, and so on. We don’t mind investing again with a sponsor we know, like, and trust, but we try to space them out because diversification spreads out risk.
The wisdom of crowds
I’m no longer so arrogant as to think that I can spot winners every time or even most times. This means I rely on the wisdom of thousands of other investors.
Before investing with a new sponsor, I ask about other passive investors’ experiences with them on the Left Field Investors or BiggerPockets forums. Then my cofounder from SparkRental and I get on a “pre-screening” call with them. If we still feel good about them, we invite them in front of our Co-Investing Club so we can all grill them together.
Every time we vet a deal from a sponsor, we collectively ask better questions. We focus more on risk and how many ways the sponsor is mitigating it than on the potential returns.
In one deal, a member happened to live five minutes away from the apartment complex in question. She gave us a local perspective on the neighborhood and the demand for this type of housing there.
In another deal, a member who works in the insurance industry pointed out just how badly the sponsor had underestimated insurance costs.
Lean on others as you diversify. Through group investments with others, I get to benefit from their expertise, not just my own.
Dollar-Cost Averaging vs. Timing the Market
I practice dollar-cost averaging in both my stock investments and my real estate investments. Every week, my roboadvisor pulls money out of my checking account to invest in a broad portfolio of ETFs. And every month, I invest $5,000 in a new passive real estate deal.
I don’t have to worry about timing the market. When other investors ask me if now is a good time to invest, I basically reply that they’re asking the wrong question.
I can’t predict the stock market or the real estate market. Either could collapse tomorrow or shoot for the stars. But by continuing to invest month in and month out, I make sure I maximize my time in the market rather than timing the market.
Plus, I enjoy cash flow in the meantime, rather than sitting with a ton of cash on the sidelines waiting around for a dip that may take years to appear.
A Numbers Game and The Law of Averages
Last year, our investment club invested in 13 deals, in line with our goal of around one a month. One or two of these investments will likely underperform or lose money. Others will overperform and exceed expectations (some already are). Most will fall in a bell curve in between and average out to strong annualized returns in the long term.
At the end of the year, I didn’t wring my hands and worry about how this or that deal was doing. They just added up to numbers on a page, all averaging each other out.
But if I had invested all of my funds in a single property or deal, you better believe I’d be thinking about that one deal all the time—especially if it was losing money or underperforming.
“By abiding by the law of averages, investors are typically able to lower the risk of downturns in fluctuating markets,” explains Nate Johnson of NeighborWho. “Instead of an ‘all or nothing’ approach, diversifying helps give investors a financial safety net while helping to ensure a consistent trajectory towards financial growth.”
And hey, even Warren Buffett can’t pick winners every time. For all his talk about how diversification is for investors who don’t know any better, Berkshire Hathaway owns stakes in over 60 businesses.
By spreading smaller amounts across many property types, in many markets, with many syndicators, I can sleep at night knowing that the law of averages will protect me. Call me an ignorant investor if you like, but I feel pretty good about a bell curve of returns on my many investments.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.