Diversification can be defined as investors putting their money in multiple companies across multiple industries to maintain a certain level of return. But diversification is equally as important—albeit somewhat different—when it comes to real estate investing.
For example, investing in an S&P 500 Index fund is one of achieving stock diversity since it invests in the 500 stocks that comprise the S&P 500 Index, which includes a cross-section of companies across 11 segments. A diversified fund like an S&P 500 Index fund allows retail investors to achieve returns that track the S&P 500 without having to buy shares of all 500 companies themselves.
An S&P 500 Index fund perfectly illustrates how stock diversification works. By spreading risk across multiple companies and industries, expected losses from some stocks can be offset with gains from others. It’s a balancing act that allows investors to maintain a certain level of return.
However, a diversified fund, like an S&P 500 Index fund, also reveals the flaw with stock diversification. What if the whole market sinks? Diversification won’t spare you from a 50.9% drop in the Dow like in 2008.
Why a Diversified Real Estate Portfolio Is Better Than a Diversified Stock Portfolio
The role of diversification in passive commercial real estate (CRE) investments is different than the role it plays with stocks because the end-game is different. The objective of investing in passive CRE investments is to compound wealth—not to merely maintain a certain level of return.
Think of passive CRE investments as part of a wealth-building machine that feeds off the cash flow from a portfolio of investments. As you feed the machine with cash, it compounds that cash through appreciation and reinvestment.
Unlike with stocks where diversification won’t save you from a crash, diversification in the passive CRE asset class has proven to insulate investors from downturns, protecting their wealth-building machine. Because investors can diversify CRE assets across geographic markets, asset classes, property types, and investment strategies, the right mix of properties will ensure uninterrupted cash flow.
With the right assets in the right markets, income may dip with some assets but won’t come to a screeching halt. This is because people don’t stop needing housing and businesses (e.g., offices, warehouses, etc.) overnight. And because CRE assets are illiquid, owners don’t unload them in a crisis like with stocks, driving down their values.
The financial crisis of 2008 and the latest pandemic-induced crisis have taught us that not all markets or assets are equally affected by downturns. Some are more resilient than others. The key is to not have all your eggs in one basket.
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