If the events of the last 2 years have taught us anything, it’s that life is unpredictable. With the exception perhaps, of death and taxes, change clearly is the only constant.
No one could have foreseen the outbreak of a global pandemic in 2019, yet it triggered a chain reaction that saw millions of people lose their lives and livelihoods. The U.S, like many countries across the world, went into economic freefall. Thousands of businesses closed their doors and entire industries were laid to ruin. Many have yet to recover.
But economic downturns are not a new phenomenon. The global financial crisis in 2008, the dotcom crash in 2001 and the Great Recession in the 1930s were all equally devastating. For savvy investors, they serve as a timely reminder of why it’s so important to diversify your investment portfolio across a number of asset types. Putting all your eggs in one basket will always leave you vulnerable to sudden fluctuations in the market.
Much like economic downturns, portfolio diversification is not new; seasoned investors have been hedging their bets and spreading their risk for years. The principles haven’t changed much over time, but the practice has continually evolved in response to global trends and market conditions.
In this 10-step guide, we’ll look at reasons for diversification, types of diversification, new areas of growth and opportunity, and where best to invest right now, given talk of an impending economic recession.
Diversification is the practice whereby you invest in different asset classes in order to protect your portfolio from underperforming investments, and boost your chances of growth. The concept works because different asset types respond differently to different economic stimuli.
Diversification is not necessarily designed to maximize returns. At any given time, investors who concentrate their capital in a limited number of investments, may outperform a diversified investor. But over time, a diversified portfolio will generally outperform more focused ones.
What diversification is designed to do, is minimize investment risk. Markets are continuously in flux, so we diversify our investments into companies, industries, assets and areas that are not subject to the same levels of risk.
Contrary to popular belief, companies can and do prosper under adversity. Disney was founded during the dark years of the Great Depression, when the nation’s need for light relief was at its peak. Sales at Cadburys and McDonalds increased by over 30% during the 2008 crash, ostensibly because people were stress-eating; and according to BCG’s 2019 report, American Express was “severely threatened in 2008 by rising default rates and falling consumer demand. After cutting costs and divesting non-core businesses to stay viable through the downturn, the company refocused on new partnerships and embraced digital technology. Its stock price rose by more than 1,000% in the decade following the crash”.
Conversely, the casualties of the Covid-19 pandemic were high. Several multi-billion Dollar industries - like airlines, automobiles, energy, leisure, and hospitality - were hard hit, and thousands of well-established businesses and household names - like Hertz, CMX Cinemas, Brooks Brothers, JC. Penney, and Virgin Atlantic – were forced to file for bankruptcy.
So whether your preference is for stocks or bonds, commodities or real estate, portfolio diversity is a critical way of mitigating risk, protecting your investments from market volatility, and growing your investment over time. Smart, regular, and disciplined investing decisions are ultimately your best way of achieving the best results over the long term, even when encountering downturns in the market.
Whether you’re just starting your diversification journey, or fine-tuning an existing strategy, it’s advisable to start with the end in mind. Consider what you want to achieve, and by when. List your goals and objectives; draw up a timeline, and remember to consider how your own preferences and biases might affect the desired outcome.
It is important to assess your appetite for risk, and your capacity to weather the financial knocks that might accrue from a high risk / high reward investment. Allocating assets is a tricky affair, because you’re trying to balance risk and surety. Stocks, hedge funds and cryptocurrencies generally offer higher returns, but come with higher risk, whereas bonds, money markets, and real estate tend to be low, slow, and steady. Figuring out where you sit on the risk spectrum depends largely on your age and financial goals. A younger investor can afford to pursue high returns because he or she has the time and resources to recover from a potential loss, whereas someone approaching retirement does not.
Investment choices are deeply personal, and all too often made on instinct and gut feel. Your family history, cultural beliefs, and attitudes to luck, money and wealth can all influence your decision-making, so be aware of them upfront. Consult widely and equip yourself with the most up-to-date deals, data and analytics. Online investment apps are an excellent way to access information from the comfort of your home or office.
There are many different ways in which investments can be diversified:
a) Asset classes - each with their own set of pros and cons, risk levels, costs and yields, degrees of complexity etc. Stocks and bonds, commodities, money markets, equities, cash, fixed income investments, cryptocurrencies, SIP, life insurance, and commercial real estate all fall into this category.
b) Companies – most of which perform differently under different conditions, and in accordance with their corporate governance, brand value, compliance, track record, and competitive advantage. You can diversify according to a company’s size, age, orientation, and market capitalization value.
c) Industries – considering the lessons learnt over the last two years, it may be wise to balance your portfolio by investing in sectors that are both on the rise, like technology, AI, and renewable energy, alongside more established sectors like education, medicine, and infrastructure.
d) Geographical location – like suburbs, cities, and states, or offshore, where you’ll enjoy tax benefits, asset protection, privacy, and a broad array of investment opportunities. Offshore investments are generally beyond the reach of all but the wealthiest of investors, and are subject to high costs and increased regulatory scrutiny.
It can take years to achieve the knowledge and understanding required to operate comfortably within this complex array of investment playing fields. You don’t need to be an economist, business analyst, or Harvard graduate to invest successfully, but you do need to be targeted, selective and strategic in your approach.
So, what does the room look like, and which lane should you choose?
Well firstly, we should acknowledge that the U.S economy staged a remarkable comeback after the COVID-19 shock. Thanks to the government stimulus policies, unemployment levels stabilized and GDP grew by 5.5% last year, the highest growth rate in nearly 4 decades. Despite this, inflation has spiked to levels not seen since the 80s, and while some of this is expected - given that certain sectors will take time to catch up with returning demand – it appears to be lasting longer than we originally hoped.
In their quarterly Insights report, Cushman and Wakefield observed that the property sector will benefit significantly from this high rate of inflation. “Our analysis shows that every 1% increase in inflation is associated with a 1.1% increase in total returns. This environment also results in lower cap rates across property sectors. In other words, commercial real estate not only protects against higher inflation but provides outsize returns specifically in these environments”.
Investors across the country are taking heed. Investing in commercial real estate allows them the additional benefit of being able to specialize within a buoyant sector, whilst also diversifying across a number of non-correlated CRE asset classes. They effectively get to enjoy the best of both worlds.
Commercial real estate has always been a safe haven asset class delivering stable returns over the medium to long term. Despite technological advances, bricks and mortar remain an attractive option because they represent a tangible asset that you can see and touch. You can visit the property to assess its size, condition, and location. And if the built structure is damaged, you still own – and can redevelop – the land.
The main advantage of a diversified CRE portfolio is that it allows you to gear towards long-term appreciation while achieving a consistent monthly income. Single-family homes for example, have higher appreciation rates but generate less income than a multi-family property, so you can acquire multi-family properties with good cash-on-cash returns, and use the income to reinvest in properties that will appreciate over time.
CRE is also an excellent hedge against inflation because property rentals are generally adjusted to keep abreast of inflation. Conversely, stocks and bonds can be negatively impacted by inflation, and yield diminishing returns.
Leverage is another advantage of CRE. Not only is CRE likely to appreciate, but most owners carry mortgages that can be leveraged while building equity.
No discussion on the benefits of CRE would be complete without mentioning tax benefits. Stocks and bonds attract capital gains taxes and, unless the investment is part of a qualified plan or retirement account, these taxes are hard to avoid. By contrast, CRE is an asset that generally grows in value over time, yet you are able to depreciate the value of the buildings, thereby reducing your annual taxable income.
Lastly, the 1013 tax-deferred exchange means you can defer paying tax on the profits from the sale of a property providing you re-invest in something similar within a prescribed period of time.
The most effective way to diversify your CRE portfolio is by asset class. Each asset class allows you to hedge against changing trends and economic fluctuations, while generating both reliable cash flow and long-term capital growth. Asset classes include:
a) Multi-family buildings - To invest successfully within this asset class, pay close attention to the property’s location, employment levels within the area, market demographics, demand, and competitor offerings. Multi-family buildings are not massively impacted by economic fluctuation and generally produce stable returns. They can be management-intensive though, and an ill-judged tenancy can bring down the appeal of a building.
b) Retail - including super regional shopping malls, strip centers, and stand-alone properties. Success within this sector depends heavily on the state of the economy. A good location is critical, as tenants will want passing trade, accessibility, secure parking, visibility, security, and access to a consumer base with good spending power. While e-commerce has definitely been the nail in the coffin for certain sectors of retail, others have continued to flourish and defied expectations.
c) Office space – including stand-alone, single/multiple tenant, and corporate headquarters, located within CBDs and suburbia. Demand for office space is driven by employment growth and employee occupancy, and is heavily dependent on the economy. The post-Covid work from home trend,and flexible work options, has certainly impacted this sector, but collaboration and human interaction are hallmarks of successful organizations, so whether this is a permanent trend, or not, remains to be seen. (The benefits of the shared workspace are well documented: Research undertaken by MIT demonstrates how people working in close proximity are three times more collaborative than those working remotely, a Harvard study found output quality was higher amongst people working closely together and a Journal of Labour Economics study showed how team members were more inclined to learn from and model the positive behaviors of their peers, when working within the same physical environment).
d) Industrial – including manufacturing facilities, ports, laboratories, warehouses, distribution centers, cold-storage, biotech and logistics. Asset performance within this sector is largely driven by inventory location requirements, labor sourcing, building configuration, transportation routes, and supply chain movement. Industrial properties generally have single tenant occupiers, and are heavily reliant on the economy. 7777Operating and capital outlay costs are generally lower than other asset classes, but tenant-specific customizations can be onerous.
a) Others – including emerging asset and sub-asset classes:
- Vacation rentals, executive short and long stay apartments
- Hotels, resorts, campsites, theme parks, even mobile home parks Click here to learn how this asset class can help make your portfolio more recession-proof.
- “Special-purpose” properties (i.e. those with unique physical features) - self-storage, parking lots, cinemas, bowling alleys, casinos, churches,
- Institutional properties including hospitals, schools and universities, prisons and military bases. These are, however, generally reserved for larger investors, or the state as they require substantially more upfront capital than other asset classes.
- Mixed-use developments – the new-age incarnation of a traditional “village” – where residential, retail, commercial, lifestyle and hospitality sit side-by-side within one precinct. These tend to be longer term projects, though, requiring massive initial capital outlay.
Whether well established or up-and-coming, these asset classes are well worth investigating - Less run-of-the-mill means less market saturation; less competition and greater demand generally translate into higher yields. On the other hand, their bespoke nature can make them difficult to operate and finance.
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When it comes to investing in CRE, there are advantages and disadvantages linked to every asset class. It is imperative that you thoroughly investigate the property and the asset class in question. Look closely at the history, financials, and past performance of the property; investigate its tenants, and the reasons they vacated; look at competitor offerings and analyze market demand.
Property is hyperlocal, so when one city is booming, another might be in decline. That’s why, in addition to diversifying by asset type, you should consider different markets. Be sure to research the area, looking closely at the following:
- Population - size, density, average age, growth, demographics
- Employment levels, job growth, job diversity, and opportunities
- Property prices, nett rentals, annual escalations, rental demand
- Access to major road, bus, rail, shipping, and air transportation routes
- Infrastructure – fibre-optics, safety and security, hospitals, schools
- Red flags – crime, pollution, political and civil unrest
- Laws and governance – types of leases, land rights, zoning rights; escrow
- Topography and natural resources
- Climate, and climate risk
Due diligence and risk analysis takes time, so use our Data Explorer to access the best deals across all regions and asset classes.
Another diversification strategy worth considering is one where you balance your portfolio with “buy to let”, “buy to sell” and “buy and hold” properties. The purpose of the first is to deliver monthly cash flow income, the second, to realize profit through the opportunistic purchase and resale of a property, and the third, to grow your initial capital investment over time. Some – like BRRRR properties (buy, rehab, rent, re-finance, repeat) have a short timeframe, while others ripen in the richness of time. “Buy to hold” properties often have sentimental value, and can be bequeathed or passed down to your children or grandchildren.
Be patient - Despite some quick wins within the BRRRR sector, CRE will always deliver better value if you hold on to it. Do extensive research upfront, and avoid the temptation to jump in and out chasing gains.
Don’t over-diversify - Diversification is not an exact science; it might be your best hedge against risk and inflation, but spreading yourself too thin, or trying to do too much too soon, will also end in disaster.
Leverage technology - Doing due diligence has always been important, but it has also been frustratingly time-consuming. Today, thanks to advances in technology, there are some excellent online tools that allow you to find and research deals without ever leaving your home or office.
Biproxi’s Data Explorer tool has revolutionized the way commercial real estate is bought and sold online by powering the CRE transaction lifecycle from list to close. Sign up today, for free
In order to maintain success, you will need to keep abreast of global markets, currencies, monetary policies, political, environmental, and economic world events. The Russia / Ukraine war is a case in point, playing havoc with fuel and food supply, resulting in a massive rise in living costs. The vigilant investor may have been able to pre-empt this, and take action, while an inattentive one may be suffering the consequences. Remember that success boils down to supply and demand, which in turn can be influenced by inflation, interest rates, and Federal Reserve policies. The more you know, the better prepared you will be.
While keeping your eyes peeled for threats, look out for innovations and industry game-changers too. Ours is an ever-evolving and rapidly changing world, full of exciting investment opportunities ripe for the picking.
Click here for up-to-the-minute industry news and insights.
Like all other investments, commercial real estate is by no means risk-free. It is - and will remain - subject to the performance of our economy. That said, a balanced, non-correlated CRE investment portfolio is an excellent hedge against inflation, able to deliver predictable returns over time, along with significant tax advantages. That makes it as close to the perfect investment, as one can hope to get.