Real estate portfolio is a recurrent term in the industry. Over time, building a real estate portfolio from scratch has emerged as a robust strategy for investors to amass a huge empire of wealth and profits. Building a real estate portfolio is a smart strategy to yield high risk-adjusted returns. Investors need to employ various investment and evaluation strategies to harness the power of the portfolio to achieve their long-term financial goals while mitigating the risk of loss and market volatility. It is noteworthy that a strong portfolio can make or break an investor’s real estate empire.
So, how should an investor leverage their real estate portfolio? Let’s discuss.
What is a Real estate portfolio?
At its core, a real estate portfolio is a collection of different investment assets in the real estate sector that is held or managed by an individual or a group of investors. A Real estate portfolio is a comprehensive compilation of all current and previous real estate deals. Specifically, it is a catalog of rental properties, investment properties, rehabs, real estate investment trusts (REITs), or real estate mutual funds. They can also include properties from different asset classes. These include residential as well as commercial buildings like multifamily apartments, industrial, office, retail properties, etc. To be precise, a real estate portfolio manifests an investor’s career-long accomplishments in the real estate sector.
A portfolio development process depends on multiple factors such as the investor’s budget, time horizon, objective, and risk tolerance. While trying to achieve their objectives, investors need to adopt the tactics that provide the key to building a successful real estate portfolio.
The one key to successfully leverage a real estate portfolio
Purchasing lots of properties over time builds an extended portfolio. However, the old adage ‘don’t put all your eggs in one basket’ becomes extremely relevant in this case. Herein, steps portfolio diversification.
Diversification is an important aspect of strengthening a real estate portfolio that stays resistant to the changing market conditions. Venturing into new projects by investing in various types of properties lies at the core of diversification. In other words, portfolio diversification in real estate is a strategy of investing in different types of assets.
Real estate is not immune from recessions or business closures. This severely impacts the demand for a property and makes the investor susceptible to losing everything or a large share of their total investable assets in case of a market decline. Hence, it makes sense to invest in a broad spectrum of assets to derive income from an alternative property type in case one fails. This strategy allows an investor to reap the financial highs of each individual market. Thus, diversifying one’s real estate portfolio counterbalances one’s losses with a steady cash flow. As a result, portfolio diversification accommodates risk mitigation and promotes healthy investment growth.
There are various ways to diversify a real estate portfolio. These include:
1. Diversifying real estate portfolio by Asset type
Investors must avoid holding look-alike properties that can endanger their portfolios. They can choose to invest in various property types ranging from single-family homes to multi-family properties. A multifamily property is more lucrative for investors as they produce higher cash flows than a single-family rental property. Furthermore, multiple units reduce the risk of vacancies and subsequent rental income loss.
The investors who want to focus on commercial real estate can invest in retail, office space, industrial, self-storage, etc. By leveraging the current trends in commercial real estate, investors can evaluate which commercial asset can be more investment-friendly in the present pandemic scenario. For instance, growth in the e-commerce industry has increased the demand for industrial and warehouse facilities. Prolonged lockdowns have made the retail properties less profitable while remote working has replaced the need for office spaces. Commercial real estate investments have less competition and generate higher cash flow than residential rentals.
2. Diversifying real estate portfolio by location
Diversifying real estate investment portfolios by geographical location is another smart strategy. As real estate is hyperlocal, one location can experience unprecedented growth while the adjoining town witnesses a decline in its growth. Hence, having an investment in Orlando and another in Dallas, and so on exposes a portfolio to several market conditions. As a result, if one locality faces a downward shift, the investor has a secured backup in another location. Moreover, it enhances the risk tolerance of the investor as they are no longer dependent on a single economy.
While selecting a location for real estate investment, investors should research the local market. They should gravitate towards regions experiencing a growing population, increasing workforce, diverse economy, school-friendly districts with low crime rates, and high demand for rental properties.
3. Diversifying real estate portfolio by risk profile
Another great way to diversify a real estate profile is according to the risk profile of the investment and the strategies that follow. There are three levels of risk profiles that determine the stability of assets and their potential risks and returns.
These are stable assets. These properties are in good condition and have low vacancy rates. As a result, they generate steady cash flows for the investor as tenants pay market rents or close to market rents. Core assets have a low-risk profile. Hence, investors adopt a buy-and-hold strategy here whereby they buy such properties and hold them for deriving rental income returns. Such properties see fewer returns in terms of capital appreciation.
Value add properties
Value add assets are buildings that require maintenance and renovations. These properties have low demand compared to core assets in terms of occupancy and market potential. After an investor buys such properties and adds value to the property in the form of upgradation, these assets are leased out to potential buyers at high rates. Although they are riskier investments than core assets, value-adding generate great returns and significant capital value appreciation.
Opportunistic or distressed assets
Opportunistic or distressed assets are the riskiest of real estate investments, Such properties require massive renovations or redevelopments in order to be suitable for selling or leasing. Distressed assets require the buy and flip strategy, where inventors buy the property for a lower price, add value to it, and then sell it at a much higher price. Although a risky investment, distressed assets undergo a complete capital appreciation and provide the maximum returns to the investors.
Investors can also acquire raw, undeveloped land. Here they have the absolute discretion to decide on whether to develop new construction or lease it to renters or resale it all together. They can also choose to hold the land in order to let it achieve a capital appreciation to its fullest.
4. Diversifying real estate portfolio by active/ passive investing
A combination of active and passive investing has also evolved as a great way to diversify a real estate portfolio. Active investors choose to invest in smaller residential properties as they want to retain their authority on every aspect of asset management.
On the contrary, passive investors reap the rewards of investing in large commercial properties without the burdens of property management. Investing tools like crowdfunding and real estate investment trusts (REITs) enable passive real estate investments.
For instance, an individual investor buys a share in a REIT that owns or finances income-producing commercial real estate projects. The REIT returns 90% of the profits it generates from any income that the properties provide to the investors in the form of a dividend. As a result, the investor becomes a part of several commercial real estate projects. Not only do they diversify their portfolio but also minimize the challenges of active property ownership.
In real estate crowdfunding, when a real estate developer identifies an investment opportunity that is too expensive to be funded on their own, they allow other individual investors to contribute some of the project’s capital in order to raise enough money to undertake the project. The investors then receive dividends from the profits generated from renting or flipping the property. As a result, these individual investors become part of a real estate project without actually buying it or managing it.
How to evaluate the performance of a real estate portfolio?
To assess the true value and success of a real estate portfolio, it is crucial to study the performance of each property. This is particularly important to recognize the areas of improvement. Investors can utilize real estate analytics to conduct this evaluation. Some of the common analytics include:
1. Net cash flow
Net cash flow is the amount of a property’s income after its expenses. The expenses include expenditures related to maintenance, utilities, and payroll. In addition to this, if an investor finances the property, they can deduct the debt service payment. Non-cash expense deductions like depreciation and amortization do not count in a property’s expenses. Property investors can calculate the net cash flow on a monthly and annual basis over a fixed period of time. Analyzing net cash flow enables investors to determine whether the property is producing positive returns or losing money on the property.
2. Cash-on-cash return
By dividing net cash flow by the cost of initial investment, investors can get cash-on-cash returns. This measures in real-time how a particular investment is performing. Furthermore, cash-cash returns help in comparing said investment with other local properties. Investors can identify whether to add value or drop it based on whether or not the property is securing returns or facing loss.
3. After repair value
It is the value of the property after value-adding via renovations and improvements. After repair value estimates the future value of the property. Investors can calculate the after repair value after comparing it with nearby properties with a similar condition, age, size, construction style, and location.
4. Economic vacancy rate
Investors can calculate the economic vacancy rate by multiplying the number of vacant units in multi-family property by a hundred. The number must be then divided by the total number of units in the building. Economic vacancy rate helps investors to determine the average vacancy rate for the property. It can also help to decide whether there is room for increasing rent in the building. If a building has a 100% occupancy rate investors can understand that their rent is below market value. Therefore raising rent in such a scenario increases the overall profits even if it leads to higher vacancies.
Buy and hold strategies in a real estate investment induces a capital appreciation of an asset. Appreciation essentially refers to the phenomenon where the value of a property increases over time. Comparing the appreciation rates of nearby properties in the adjoining area, helps the investors to decide whether or not to hold on to a property and its long-term benefits. Ideal property investments will appreciate at a rate that is better than or similar to the national average.
The bottom line
Every real estate investor aims to build an extended portfolio to secure great returns and protect their wealth. However, leveraging diversification to strengthen the overall growth of investors while making them recession-proof is the smart and the safest way forward. In addition to this, using real estate analytics to keep a tab on the financials and individual property performance also enables achieving the larger investment goals.