To this day, the first rule of reducing risk in your investment portfolio remains diversification.
You’ve heard it since you were a kid: “Don’t put all your eggs in one basket.” It was true then, it’s true now, and it will be true 25 years from now.
Unfortunately, direct real estate ownership comes with challenges for diversification. When a 20 percent down payment on a median U.S. home costs around $50,000, that makes for a lot of eggs in a single basket.
But in today’s world you have plenty of options for simple and effective diversification. Try these easy ways to diversify your portfolio beyond rental properties, so you can weather the next economic storm without fear.
How to Diversify Your Investment Portfolio
1. Index Funds
In the world of stocks, an index fund simply mimics major stock indexes, such as the S&P 500 or the Russell 2000. Unlike actively-managed mutual funds, with a live manager picking and choosing stocks, index funds operate passively, just mirroring the index.
This makes them much cheaper, without having to pay some inflated egomaniac on Wall Street to play the market with your money. Some index funds charge no expense ratios whatsoever!
Yet you get broad exposure to hundreds or even thousands of stocks with each share that you own.
If you’re new to stock investing, I recommend opening an account with a robo-advisor to pick a series of funds on your behalf. I personally use Charles Schwab’s service, which is 100 percent free if you invest at least $5,000. You fill out a questionnaire, and based on your answers, they propose index funds for you. Once you approve their selections, you can set up automated recurring transfers to the account.
Thus, both your savings transfers and your stock investing happen on autopilot. Which I especially love as a real estate investor, since direct property investing takes so much of my time and effort.
Word to the wise: diversify within your stock investments by market cap, sector, and geography. Invest in small cap and large cap funds, both in the U.S. and internationally.
2. Publicly Traded REITs
Using your brokerage account, you can invest not just in stocks or bonds, but also indirectly in real estate. Real estate investments trusts (REITs) trade like stocks or funds, but they own real estate.
That makes for a completely liquid way to invest in real estate. You can buy or sell instantaneously, unlike direct property investing.
The downside? That liquidity makes REIT prices far more volatile than property prices. And because they trade on stock exchanges, they tend to move more in concert with stocks than actual real estate prices do. Which, in turn, reduces their diversification benefit.
By law, REITs must pay out at least 90 percent of their profits in the form of dividends. So they tend to pay high dividend yields, but unfortunately don’t tend to appreciate much. It’s hard for REIT managers to buy additional properties, when they have to pay out 90 percent of their proceeds in dividends.
3. Private REITs
Over the last 10 years, crowdfunding has created a new option for investing in real estate.
It works like this: the company buys properties, typically commercial or apartment buildings, as part of a fund’s portfolio. To raise capital, the company allows the public to buy shares in the fund. Some funds pay dividends, others simply grow in value as the fund reinvests profits to buy more properties.
Investors buy shares directly with the company, rather than through a public stock exchange. That reduces SEC oversight, which can boost the risk but the lower regulation also leaves more flexibility.
Still, these crowdfunding companies must operate under the SEC’s rules. They have two compliance options: they can opt for minimal regulation, but it restricts them to only accepting money from accredited (wealthy) investors. Alternatively, they can accept more oversight and open investment to anyone, not just wealthy investors who can legally waive their protections.
If you have less than an investable net worth of $1,000,000 or don’t earn $200,000/year ($300,000 for married couples), you don’t qualify as an accredited investor and have fewer choices for investing in private REITs. But you do have a few; I’ve personally invested in Fundrise and Streitwise and have had largely positive experiences so far.
Related: What Belongs in Your Net Worth (& What Doesn’t)
Read the fine print carefully though, and above all else, understand that these are usually long-term investments. Many restrict your ability to sell shares in your first five years of ownership—investor beware!
4. Crowdfunded Real Estate-Secured Debt
Real estate crowdfunding websites offer another model as well: debt secured by real estate.
These are often hard money lenders, loaning money to house flippers to buy and renovate properties. As such, the loans are short-term and high-interest: a great combination for lenders—and for you, as the capital investor.
They make the loan to the real estate investor, then raise money from the public to reimburse their coffers for the next loan. Some create a pooled fund you can invest in, while others let you pick and choose individual loans like peer-to-peer lending secured by real estate. In the latter case, the loans pay interest based on risk.
Sometimes they pay monthly interest, other times they pay out all interest when the flipper pays off the loan in full. But these typically involve much shorter-term investments than private REITs, since the loan terms are usually just nine to 12 months.
Non-accredited investors should check out Groundfloor. They allow anyone to invest with as little as $10, invested in the loan of your choice.
5. Private Notes
Alternatively, you can skip the middleman entirely and just lend directly to real estate investors you know.
A “note” is the name of the legal contract for a loan. Thus, a private note is simply a private loan between you and another real estate investor.
Related: The Beginner’s Guide to Building Wealth With Private Notes
They come with few protections for the lender. If your borrower defaults on you, you have little recourse other than pursuing a money judgment or perhaps foreclosing if you secured a lien against the property.
So, you should only lend money in private notes to other investors who you know and trust. Investors with a track record of success. Investors you can trust to actually pay back your money.
6. Real Estate Syndications
Real estate syndications have grown in popularity in recent years. But most of them still only allow accredited investors to participate.
It works like this. An (hopefully) experienced investor finds a great deal on a commercial property. They don’t have all the money they need to buy the property on their own, so they turn to friends, colleagues, and other wealthy investors to raise the remaining money.
The syndicator takes on the work of renovating and managing the property. The participating investors get fractional ownership in the property, based on their investment.
For example, you invest $50,000 to get 5 percent ownership in a $1,000,000 apartment building, rather than putting that $50,000 down on a single family home. You don’t have to do any work, you just earn distribution income, and a big payout when and if the syndicator sells the property.
Plus you get to diversify into commercial real estate.
7. Long-Distance Turnkey Properties
Rental investors tend to invest in their own backyard. It’s the market they know, their comfort zone.
I bought 15 properties in my home city of Baltimore. I’m down to just one property there, and I wish I didn’t own that either. Between anti-landlord regulation, a corrupt local government, low-quality tenants, and poor economic fundamentals, I will never buy property there again.
But it’s what I knew when I first started investing. So I had almost no diversification in my real estate portfolio, and I suffered huge losses as a result.
Even within your residential rental portfolio, you can diversify geographically. Look into out-of-state turnkey properties through platforms like Roofstock or through local turnkey sellers.
For that matter, nothing says you can only buy property in the U.S. You can diversify into international real estate as well, particularly if you find a property that might one day make a great post-retirement home base.
Final Thoughts
You may have noticed I didn’t include one of the most common paper assets: bonds.
In the 21st century, bonds have stubbornly continued to pay low yields, partially because low interest rates have become the new normal. That’s all fine and dandy for governments who love to spend freely with minimal interest on debt, but it doesn’t do retirees any favors.
As workers approach retirement, conventional wisdom suggests they move more of their money out of high-volatility investments like stocks and into lower-risk bonds. It helps them avoid sequence of returns risk: the risk of a market crash early in your retirement, before your portfolio has a chance to compound into unassailable heights.
I invest in real estate as an alternative to bonds. One oft-ignored benefit of reaching financial independence earlier in life is that you can keep all your money in high-return investments as long as you have the option to earn active income. If the stock market crashes, you don’t want to be forced to sell any stocks while prices remain low. Being relatively young, you can always return to work in some capacity to bring in a little cash and avoid having to sell any stocks.
Or you can diversify and bring in passive income from so many different sources that even when the stock market crashes, you can still cover your living expenses with your other income.
Diversify, and prosper.
What are you doing to diversify your portfolio? What role does real estate play in it? Do you invest in bonds at all?
Comment below.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
