Financial planners and investment advisors emphasize the importance of diversification in a portfolio of investments, as well they should.
Diversification reduces the impact of poor performance on the part of any particular company or sector. Diversification also helps the investor achieve balanced results by combining the equity appreciation from growth-oriented securities or funds with the current cash flow provided by income-oriented funds, utility stocks and bonds.
The particular mix of equity and cash flow can be adjusted to the financial needs and goals of the investor.
Similar logic can also apply to buy-and-hold real estate investment. Diversification can provide a cushion against a particular property that performs poorly, as well as balance the overall financial results for the investor.
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Benefits of a Diverse Portfolio
First, holding just one property involves much more risk than holding a portfolio of 3, 5 or 10 properties since any given property can perform poorly from time to time due to tenant behavior or the need for capital investment (ex. HVAC system roof, etc.). With a portfolio, the income from the other properties can cover for the cash flow shortfall associated with the problem property.
Beyond the obvious benefit of reducing individual property risk, diversification can also help balance the portfolio’s results according to the preferences and needs of the investor. Different cities, submarkets, levels of leverage and property types offer varying return profiles that investors can combine to achieve a balanced portfolio with a performance mix that matches the financial target.
Combining Diverse Property Investments
Low-cost properties in more modest neighborhoods may offer exceptional cash flow, but may not have potential to achieve any significant appreciation. Those properties may play a role similar to utility stocks that provide high dividend yields, but often do not promise great growth potential.
Other, more expensive properties in more affluent areas, particularly in cities with strong and growing economies, may offer better appreciation potential, but less substantial immediate cash flow results. Combining property types provides a combination of current income and future equity growth and also provides diversification against the risk of deteriorating property values in a particular submarket.
Many investors adopt a strategy of investing in the property type that they find most comfortable, but a diversified approach can provide a cash flow floor for the investor who is looking primarily for gains through property appreciation, or similarly a better inflation hedge for the investor that is primarily looking for current cash flow.
Optimizing the Use of Leverage
With a diversified approach, an investor may also optimize the use of leverage with some simple strategizing. With the current limitation of ten conventional loans, an investor can plan to use financing on the more expensive properties in the portfolio to maximize longterm borrowing capacity.
Leverage amplifies both appreciation and to a lesser extent cash returns. However, it is a mistake to focus on the effect of leverage only on a particular property because at the end of the day, the portfolio will perform as an aggregate.
The cash flow from all of the properties will be used to service all of the debt used to finance the purchase of any of the properties.
A diversified portfolio of properties can provide an investor with steady cash flow and healthy equity growth over time, while maximizing the benefits of applying leverage to amplify results.
Of course, the most important diversification step a savvy investor makes occurs at the first purchase of real property. As BiggerPockets readers well know, a real asset that generates income is a terrific hedge against inflation and almost completely uncorrelated to the volatile stock market.
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