The Importance of Diversification in Passive Real Estate Investing

Putting all of your eggs in one basket can be very dangerous in real estate investing. Jeremy Roll, who currently invests in more than 50 different opportunities, is a firm believer in the importance of a diversified investment strategy. In our recent conversation, he explains how he personally approaches diversification by breaking it down into the 3 most essential pieces – geography, asset-class, and operators.

Geography Diversification

Some investors like to invest locally, somewhere that they can drive too within an hour or two. Others will invest out-of-state, but all in one sub-market. There are thousands of different ways to invest and most of them are perfectly fine. However, the problem with having all of your properties concentrated in one geographic location is that you are much more susceptible to weather and economic related risks.

For example, if there is a major earthquake and you own 10 properties within 3 miles of each other that are all destroyed, you are in trouble. While this is extreme, it is still a risk (Jeremy calls these 1% risks).

Recently, Florida was hit by hurricanes, which most likely had a major affect on some real estate. While it might be okay to own real estate in Florida, if you were heavily invested in one Floridian location and one hurricane wiped of half of your properties, again, you are in trouble.

Another weather related example – Jeremy invests in 6 different funds with some very large mobile home park operators, with one being the 5th largest in the world. This operator shared a story about why they have no qualms with investing in areas that have tornados, but they avoid hurricane areas. The reasoning was that when a hurricane hits, it typically wipes out a massive territory. As a result, the different governmental agencies and insurance companies are too overwhelmed and can’t handle it, so it takes forever to repair the damage. Whereas for tornadoes, a more isolated area is affected, so FEMA will come in immediately and help. Isolated areas are much more manageable. In this specific situation, these mobile home operators had all of their homes replaced for free. The lesson here is that tornados are manageable and hurricanes are unmanageable.

Asides from weather related risks, another reason to diversify across different geographical areas is that each has it’s own economies and applicable challenges. If you are invested in a city that relies heavily on a specific employer, if they decide to relocate their plant across the country, you are in trouble. There are countless other examples, so all in all, it is important to spread your investments out across different geographical areas.

Asset-Class Diversification

It is also important to diversify across different asset classes, both from an asset-type and tenant perspective. For example, Jeremy won’t invest in apartments unless they are 100 units of more. If one person leaves, his vacancy rates increases by 1%. On the opposite end, if you invest in a 4plex and one tenant leaves, your vacancy rate increases by 25%!

Diversifying across asset-types is key because some perform better in a growing economy, while others perform better, or are at least more manageable, during a downturn. For example, office and retail don’t perform as well during a good economy, but can go through a recession well. Specifically, retail with anchor tenants – big grocery stores, CVS, Walgreens. Mobile home and self-storage can perform even better during a down turn. In 2009, self-storage vacancy only increased by 1%. This is probably due to the increase in demand that came from homeowners who were foreclosed on and need a place to store all their items.

In the long-term, you want to be as diversified as possible. In doing so, if we are in a good economy or a bad economy, the cash flow is still going to come in. This is especially important if, like Jeremy, you are dependent on cash flow to live off of.

Jeremy does not recommend that you invest in every asset class. He doesn’t invest in hotel or industrial space, for example. On average, these asset classes tend to do really well in an upturn or positive economy. However, they tend to have really quick revenue reductions during a downturn. He doesn’t want to be exposed to that volatility. Therefore, it is important that you diversify as much as possible, but make sure that you are comfortable in all the asset classes you select.

Operator Diversification

Whenever you invest passively, you are trading control for diversification. You are giving someone else control of the day-to-day operations and you are probably investing with multiple different investors, so your control is minimized. Therefore, if you are going to give up control, you better trade it for diversification. Jeremy finds that there is always a 1% risk with operators, due to the possibility of mismanagement, fraud, a Ponzi Scheme, etc. You are increasing your risk inherently by being a passive investor. To mitigate that risk, diversify across operators. Don’t have too many eggs in one basket.

Everyone has their own take on maximum exposure an investor should have in terms of number of operators. The common number that Jeremy sees is that people don’t like to be exposed to an operator with more than 5% to 10% of their total capital. The same applies to geography and asset-classes as well.

It is also important to keep in mind that proper diversification takes a long time, but it is the best way to reduce risk. The more diversified, the better. Jeremy recommends that you shouldn’t invest more than 5% of your capital into an opportunity. This means that your goal should be to diversify across at least 20 different opportunities. At that point, you can determine how many operators you are comfortable with – 1, 3, 5 or more, depending on the person. It is very subjective and depends on what you are comfortable with.

What are some stories of problems you have come across that were a direct result of not being diversified enough?