Why Diversification (of Your Portfolio, Financing & Everything Else) Truly is the Only Free Lunch
Did somebody say free lunch?
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“Diversification is the only free lunch” is a saying normally applied to mainstream investing to protect an investor from risk if an asset goes south. Buy stocks and bonds. Add gold to your portfolio. Buy a REIT. Choose an index fund.
Smart folks use this thinking to come to the conclusion that stuffing your 401k with stock from your company might not be the best idea in the world. I worked for Enron. Can you guess how I learned this lesson?
So, what does it look like to be diversified as a small real estate investor? How do we use diversification to protect ourselves when investing real estate? Have you ever stopped to think about just how many sources of risk there are in a real estate transaction?
Diversification doesn’t necessarily mean do a little bit of everything. But with good planning, you can diversify within your chosen real estate niche to improve odds of (great) success.
I would like to share with you what I have learned over 20 years of playing Monopoly with real houses.
Diversify Your Portfolio
I own about 160 units. In 1999, my first purchase was a 3/1 that was fire damaged. The house was in my hometown—a small college burg with a population under 20,000. A couple of years later, I purchased a fourplex in a student-populated part of town. As my unit count grew from my first house until about 50 units, I balanced—or rather, I diversified—my types of housing. The rent-to-price ratio is better on student housing while turnover is higher. This is offset by the slightly steadier demographic in single-family homes. Over time, this strategy has helped me weather summer months when rent collections usually drop.
Once I reached a few dozen units, my buying power and appetite started exceeding what was on the local market. I made several purchases in small, nearby towns, adding another type of diversification to my portfolio and insulating cash flow further from seasonal student housing swings.
More importantly, the nearby towns tended to have less expensive real estate and lower rents. This may not sound ideal, but this housing was excellent for solid working families at an economic point distinct from the students and demographic I had focused on in my base hometown.
As my real estate confidence grew, I decided to look for properties in Pensacola, FL near where family lived, thinking that my accountant would allow me to deduct some of my annual travel costs on my taxes. I added a triplex, duplex, and beach property to the mix. Owning Florida property further boosted my interest in diversification. In the last year, I have added 10 duplexes and 11 single family homes on the Mississippi gulf coast.
Today, I own properties in three states—Louisiana, Florida, and Mississippi. The economies of the three regions include higher education, tourism, defense contractors, and military bases. As a bonus, I have been able to find much greater returns than in my small hometown. The units are highly varied—student housing, vacation rentals, solid blue-collar houses, and one resort-type beach house. There is obviously more I could do, but these assets are solidly diversified.
Diversify Your Financing
Long shall live the debate over whether to structure debt for cash flow or for equity. This depends on so many factors: available financing when the loan is taken out, personal risk tolerance, personal paths of least resistance, age of investor, mood, financial goals, and many, many others.
My personal philosophy has been to (you guessed it) diversify!
Everyone has heard of properties that cash flow superbly—or that cash flow poorly. Or that cash flow well, except for that time they were vacant for six months because you got busy at work and couldn’t get them rehabbed. The point is that when you invest in rental property, there is a wide spectrum of outcomes—and no one has a crystal ball.
I suspect that most investors opting to get everything financed for 30 years fall into one of two camps. The first is the person who wants maximum cash flow so they can invest in more properties. This takes a great deal of discipline over many years. You shouldn’t go buy a new toy (or Jeep, in my case) whenever the mood strikes and there are a few bucks floating around in the rental account.
The investor that opts to only buy properties with 15-year financing has a great mindset for automatic savings. Properties that are paid off earlier in life will be much less risk later in life when the funds may be needed or life situations change. However, this investor will be challenged to put all of their money to work for lack of deals that cash flow, resulting in a slower pace or costlier reinvestment of profits.
I have about 10 loans that are mostly 15-20 year amortizations with 3 or 5-year balloons because I have chosen to do business with local commercial banks. That has, however, put me in a position to be at greater risk from rising interest rates. By the end of the year, though, 20% of my debt portfolio will be diversified in 10-year-or-longer notes with 30-year amortizations. I plan use the additional cash flow to pay down small loans on individual properties and as short-term savings.
Diversify Everywhere it Makes Sense
An investor should diversify in every aspect of real estate investment. For example, make offers on multiple properties to mitigate the risk of deal falling through. In May, I made offers on about 20 houses in Jackson County, MS and signed a contract for 11.
Seek funding from multiple sources in parallel when under contract. Don’t let one “no” put you in a bind to close an investment. I applied to four different banks at the same time for the Jackson County houses. I have three different go-to local banks with whom I have long-term relationships.
Diversify property managers. What? Wait, let me explain. Having multiple property managers just sounds like a headache. And it’s not for everyone. But using more than one company in the same locale to manage properties has its benefits:
- Each property manager is a real estate broker. Having a business relationship with multiple property managers gains an investor access to more deals than they would have otherwise. I have bought many off-market properties at great prices this way.
- Each property manager markets in a different way. Some are heavier on social media, while others might emphasize print advertising. Some have a reputation for maintenance; others for the best deals. I have increased my “shelf space” and appeal in my small local market by having more than one manager.
- Each property manager has access to different maintenance crafts.
Be smart. Diversify. Ask all the “what if” questions—and then think about how you can prepare for different outcomes.
How do you diversify your investments to mitigate risk and maximize opportunity?
Weigh in with a comment!