How to Diversify Your Buy and Hold Real Estate Investments

In finance, portfolio diversification is the way to grow and protect your assets. Though diversification is typically understood as holding different types of investments or employing different investment strategies, it is still more than possible to diversify a portfolio with only one kind of asset (like single-family rental properties).

Every investor knows the importance of diversification. It goes back to the adage, “Don’t put all your eggs in one basket.”

For buy-and-hold real estate investors, diversification may seem like more of a challenge. After all, you’re employing one specific strategy to achieve your goals. In many cases, you also focus on one particular type of property. Where is diversity to be found?

Believe it or not, you can effectively diversify your portfolio while specializing in one type of strategy or asset.

How diversification protects & grows assets

In real estate investment, the chief role of portfolio diversification is to both protect and grow your wealth. How does it do this, exactly?

Hedging against risk

The primary function of diversification is to hedge against risk. As investors, we want to mitigate risk exposure as much as possible. Risk is inherent in any type of investment. Reducing unnecessary risks sets your portfolio on a firm foundation.

For example, if you invest only in stocks and the stock market crashes, your portfolio will be in jeopardy. Similarly, investing only in one real estate market and facing a market crash, natural disaster, or other local crisis can negatively impact your portfolio. When your portfolio is impacted, passive income and appreciation are also impacted.

Diversification effectively allows you to weather these unexpected downturns and circumstances. By sustaining your cash flow and net worth through multiple holdings, you can create a barrier and mitigate some of the risk.

Scaling for wealth

Success in any kind of investing demands that we grow. Portfolio growth is essential for building real, lasting wealth. When we scale our portfolio through diversification, we create multiple avenues that generate wealth. Not only does this increase our ability to acquire new assets for a growing portfolio, but it allows us to continue earning even if one of our assets is struggling.

Consistency

The more investments you hold, the less one investment will skew your outcomes. In the long term, a diverse portfolio gives a more clear and consistent view of your growth and overall performance.

Why buy-and-hold single-family?

In two decades as a real estate investor, I have specialized in single-family rental (SFR) properties. I’ve focused on what I consider good buy-and-hold markets based on data. Buy-and-hold has long been regarded as a more reliable way to invest in real estate. It is a strategy that is far less dependent on the real estate cycle or timing the market.

Personally, I look at a buy-and-hold market as one where the median price of housing is at or below median U.S. housing prices, among other data points. Market growth, job growth, and strength of industry are three strong components I look for in a market.

Investing in SFRs has only grown in popularity in the wake of the Great Recession in 2008. When we look at the statistics, we see the U.S. homeownership rate peaking in 2004 at 69.2%. In 2019, that rate was 65.1%.

While this doesn’t seem all that significant, it is estimated that every 1% drop in the homeownership rate represents some 750,000 new renters. Not only that, but rental rates have steadily increased over the past 20 years.

The Great Recession led to an increase in renters, but 2020’s COVID-19 pandemic accelerated the move from multifamily housing to SFRs for many residents, too. This is due, in part, to the demand for more personal space between neighbors and a reprieve from the density of cities and apartments. Commercial and multifamily real estate, in particular, struggled in 2020.

Cash flow & appreciation

While investors benefit from single-family rentals in a number of ways, the most prominent is the combination of cash flow and appreciation. These properties not only generate monthly cash flow, they also, like most real estate, appreciate over time. As an investor holds the property, both increase. Once investors pay off any existing mortgage balances (often with rental payments), cash flow only grows.

Leverage

Few investments benefit from leverage like real estate. Leverage is the ability to use other people’s money to acquire assets. In the case of real estate, this means acquiring bank loans in the form of mortgages. Rather than putting up $100,000 of your own money to buy an asset that generates passive income, you can put up $20,000 of your own money as a down payment while the bank pays for the rest.

While outstanding mortgages are nothing to take lightly, this strategy allows investors to scale more quickly while using less of their own capital. Leverage facilitates increased portfolio diversification. If you really want to understand why using leverage may be the single best wealth building and diversification strategy in 2021, read J. Scott’s post on why the value of leverage you place may be more valuable than the property itself.

Hedging against inflation

Real estate is known to be a hedge against inflation. These kinds of investments are known for retaining or increasing their value in the face of fluctuating currency values. Its low volatility combined with its inflation hedge makes it a great option for diversification against, say, stocks, which can be highly volatile.

Exit strategy options

Every investor needs an exit strategy. One major advantage of SFRs is the investor’s increased options for resale. A multifamily or commercial property has a limited pool of potential buyers, whereas a single-family property can be sold to potential homeowners, other investors, or back to an investment company.

Tax advantages

Real estate is highly incentivized by the government through tax benefits. Operating expense deductions, accelerated depreciation, mortgage interest, pass-through deductions, management and repair fees, property tax and insurance deductions … the list goes on. There are also tax-deferral strategies, like the 1031 Exchange. Always consult a tax professional who has experience dealing with real estate investors to ensure that you maximize your tax advantages.

Single-family rentals make for excellent investments for these reasons—and many more. But as a real estate investor, is it possible to diversify a portfolio that only contains single-family rentals?

Can you diversify if you only invest in SFRs?

A portfolio is most diversified when it has a variety of investment types. However, an investor’s ability to diversify is often limited by their assets and experience. A new investor, for example, probably shouldn’t jump right into buying commercial or industrial real estate. Residential real estate is the best entry point for new investors.

Whether you’re a new investor looking to diversify your portfolio or someone with more experience, know that it is possible and necessary to diversify a portfolio of residential real estate.

There are two primary ways to do this.

Increase your properties

The simplest way to diversify is to acquire more properties. In the instance of a buy-and-hold investor, more properties mean more streams of income, more appreciation, and greater net worth.

Should you encounter a vacancy or emergency, you will have other properties that can offset this loss. Instead of earning nothing one month as the owner of a single property, maybe your earnings are reduced only by a fifth, a tenth, or even less, depending on how many properties you own.

Vary by location

We all have the saying burned into our brains: location, location, location. While we most often think of this in terms of the best place to buy for value and future appreciation, it also relates to portfolio diversification. Spreading your properties across multiple markets helps mitigate economic risk. We can see a prime example of this if we look back to the Great Recession.

Many primary, over-inflated markets bottomed out, whereas more evenly, modestly appreciating markets dropped with less severity, and thus bounced back more quickly. Houston, Texas, is a key example of this when we look back at the numbers. It was one of the hottest markets (and continues to be so) post-recession.

Investing in multiple markets allows you to focus on different price points, demographics, and economic conditions. As these fluctuate and change over the years, you can rest easy knowing that a downturn in one market doesn’t mean a downturn for your portfolio.

Naturally, you have more options for diversification if you also pursue different types of properties. In my day-to-day role, I have worked with both investors who exclusively pursue turnkey SFRs and investors who own additional and varied types of properties. Many invest in stocks, bonds, syndications, and lending. All of those help them to diversify.

With that said, diversification is possible (and simple) within a buy-and-hold, single-family rental strategy.

The key role of SFRs in a diverse portfolio

Risk in real estate investment can be difficult to truly assess. This is because risk comes from a wide variety of factors. From the renovation of a property to its location, the management team, and even the local economy, demographics, and price point, these are all risk factors.

Investments are all about a balance between risk and reward. We know that, traditionally, the more risk involved with an investment, the greater its potential returns. We do not see realistic investments that are both low-risk/no-risk and high-return. If anyone claims this, it’s likely a scam.

Single-family investment properties play a key role in an investment portfolio as a core investment. When you’re trying to balance a portfolio’s risk, you need core investments to craft a stable foundation. Single-family rentals are ideal for building this foundation due to their time-tested nature.

This is particularly true if you are targeting stable, growing real estate markets that have demonstrated strong numbers without too much volatility. Just refer back to the link above showing the historical nature of homeownership to see that right now the percentage of renters is high even with a growing population. A core real estate investment typically comes at a slightly higher price point but with lower vacancy rates (more stable, long-term residents) in more desirable neighborhoods. Thus, these investments are reliable.

The risk in scaling

While there is a justified emphasis on scaling (and thus diversifying) one’s portfolio, investors must be wary of scaling too much too fast. No investment strategy, diversification included, will fully eliminate real estate investment risk.

Investors run the risk of hurting themselves if they over-extend their assets in the name of diversification. Scaling too quickly can be overwhelming.

I will never forget the day I decided to sell my first portfolio and start over. I had grown to 56 low-price single-family homes, all in the same city. Ask me how I know it’s important to diversify! I was staring at a pile of 80+ pieces of mail from one day that I needed to go through for my properties.

Money is an important resource and so is your time. Make sure you account for both when growing and diversifying.

Proper diversification and risk

Proper diversification comes from carefully vetting and weighing your investment opportunities. Rather than investing in 56 sub-par properties, you can find more success and stability by investing in 10 great properties that fit your vision and long-term goals.

A diversification strategy won’t reduce your risk if all you invest in are high-risk assets. This is why you need those core investments first. The investments you can rely on to generate consistent value.

Scale as you can and are comfortable with. Prioritize solid, stable investment opportunities over high-risk ventures, especially in the beginning. While it may not be “exciting,” it will give you the foundation necessary to build wealth, manage greater risks, and succeed in real estate investment.

Finally, diversify—but not at the cost of your real goals. Don’t seize an opportunity just to diversify if it is not a type of property or strategy you want to be a part of. Assess your short and long-term goals to ensure that the opportunities you pursue fit.

As a buy-and-hold investor, you should be looking at a seven- to 10-year horizon. Avoid unnecessary loss and risk through careful, thoughtful scaling that is consistent with your vision for diversifying your portfolio and succeeding as a real estate investor.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.