Ranging between 120 and “hundreds.” This renders specific crowdfunding platforms unsuitable for non-speculative investments.
Since this post was published in 2015, things have substantially improved for some investors. Many real estate crowdfunding platforms have expanded beyond single-property investments, allowing pooled investments in many properties.
These enable an investor to swiftly amass portfolios of over 120 properties for efficient diversification. For instance, a single investment in the BroadMark hard money loan fund gives an investor access to hundreds of homes.
Therefore, the information below is no longer applicable in all situations. However, I’m preserving this section for people who continue to invest only in single-property ventures (since this is still an issue for them).
Over time, the direct real estate market has generated returns over 9.2 percent, with volatility comparable to or lower than that of bonds. Therefore, you may believe that any investment is entirely secure.
Unfortunately, this is not true. The excellent stability of the averages of hundreds of thousands of characteristics conceals the unstable volatility of many specific properties. A laundry list of factors might cause the property value and/or income of your particular investment to decline. When this occurs, your profits may fall below average (and you may lose a portion or all of your original investment).
How Things May Go Awry
For instance:
- Personal property danger (unexpected repairs, unexpected environmental cleanup, etc.)
- Risk to the landlord’s property (unanticipated late payment, random default, unexpected maintenance, etc.)
- Operator risk (unexpected financial issues, late payment, unexpected default)
- Geographical dangers: (unfavorable conditions in the local area, metropolitan area, country region, or nationally).
- Economic dangers: (unfavorable conditions in the current business cycle)
- Property type risk: adverse situations affecting commercial and residential properties. Under difficult commercial circumstances for various niches (retail, industrial, residences, public storage, warehouses, medical facilities, malls, downtown offices, suburban offices, etc.)
- Investment strategy risk: (unfavorable conditions for core, core plus, value-added, or opportunistic strategies)
The Answer: Diversity
Therefore, it is essential to diversify your assets over many properties. By doing so, the impact of a few “bad apples” is neutralized by the presence of the others.
Great. So how many do you need?
No Individual Figure
After many questions, I have been unable to identify an unbiased study that gives a single number in answer to this topic. (If you are aware of an investigation, please inform me!)
While we may not be able to identify an exact number, it is pretty simple to estimate a range for adequate diversity.
What Are the Opinions of Institutional Investors?
Institutional investors have invested in real estate directly for decades. And they like conversing. I discovered several references to the importance of diversity in institutional research and informative materials that mentioned diversification 100 times or more.
For instance, “IFEBP Benefits” (a publication for institutional investors in benefit plans) stated:
Real estate managers should reduce the likelihood and magnitude of market-related losses by diversifying assets among many properties (often hundreds), property kinds, locations, and tenants.
The above citation refers to core assets, the most conservative and least diversified real estate investments.
If “sometimes hundreds” is the expectation for a good core real estate manager, then a portfolio with a mix of strategies (core plus, value-added, opportunistic) is much greater.
Hundreds Of Properties!? Really?
That is a considerable amount.
Therefore, it is prudent to do a back-of-the-napkin reality check. Let’s rapidly compute the number of attributes required for diversification among the most significant and most prevalent diversifiers:
- Strategy: 4 (core, core plus, value-added, opportunistic)
- Region: 5 (Northeast, Northwest, Southeast, Southwest, Midwest)
- Asset type: 6 (office, retail, apartment, industrial, residential, other)
4 × 5 x 6 Equals 120 characteristics.
This is the bare minimum and does not include other diversity that you may deem essential.
- If you deemed it vital to diversify between debt and equity investments, you would need 240 properties.
- If you believe the areas mentioned above are too diverse to effectively reduce geography risk, there is a strong case for dividing each region into two smaller sub-regions, which would need 240 properties.
- According to Meketa Investment Group, the minimal need for diversity is the vintage year (to eliminate the significant market cycle risk that real estate has). I do not deliberately diversify in this manner since I am pretty active and stay on top of market cycles. However, a passive investor would gain significantly from this kind of diversification. This would need a portfolio of hundreds of homes.
Whether or not these variables are addressed, the range is between 120 and “hundreds.” Our reality check on a piece of paper matches that of institutional investors.
The Primary Issue Facing the Industry
If this is true, the crowdfunding business for real estate has a significant issue. Current minimums are too high for the ordinary investor to diversify effectively.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.