How to Build a Real Estate Portfolio
Commercial real estate offers several advantages over other common investment vehicles like equities, bonds, mutual funds, and other traditional additions to retirement portfolios. Investors seek out real estate investments for the potential of steady cash flow, asset appreciation, tax advantages, and diversification benefits. Many of these benefits are magnified for high-income individuals, like physicians.
For new and experienced investors alike, real estate is an attractive asset class. But before jumping into the world of commercial real estate investing, it is imperative that you build a base of foundational knowledge relating to the sector. Mission-critical study areas include projecting expected returns, comparing real estate to other potential investment vehicles, and how to safely and profitably add real estate assets to an investment or retirement portfolio. Remember that investing is a marathon, and that consistency in your real estate portfolio can generate returns far above any one transaction or acquisition.
Judging Risk and Return for a Commercial Real Estate Portfolio
There are a few areas that tend to trip up novice investors. Unrealistic expectations are often a challenge, especially relating to the projected ROI of a given acquisition.
Insufficient risk analysis is a typical issue faced by new real estate investors. The research and risk analysis procedures for commercial real estate assets are wildly different than traditional equities, bonds, mutual funds, etc. Instead of reading detailed analyst reports and detailed financials for a particular stock or mutual fund, real estate investors need to research regional and local markets, individual properties or property portfolios, local tenant laws and regulations, and a whole host of other area and property-specific factors. Without the ability to collect and review the right data, commercial real estate investors dramatically increase their risk of loss or below expected returns.
Finally, new investors often fail to allocate real estate in their portfolio correctly. As real estate assets can be more expensive to buy into compared to equities, investors will often over-allocate real estate in their portfolio, thus drastically increasing their risk levels. Conversely, under-allocation of real estate within a portfolio leaves profit on the table and can lead to situations where deals are not adequately capitalized, thus decreasing expected profits and increasing risk levels.
As we mentioned earlier, the risk analysis procedure for commercial real estate investments is not as straightforward as standard equities. To combat this, industry groups have created several benchmarks that track both public and private real estate investment sectors. Two of the most useful are the NCREIF Property Index, which tracks private returns, and the NAREIT Index, which tracks public returns. When tracking REITs, just like equities and bonds, public data relating to performance is available to investors. However, private real estate, like other private asset classes like venture capital and private equity, are much harder to measure due to the lack of transparency regarding financial data.
Both risk-adjusted returns and volatility are much harder to measure within the private sector. While the NCREIF and NAREIT indexes are not perfect, they can help investors level-set their return expectations for commercial real estate assets. Think of these indexes in the same way you would view the Dow Jones Industrial Average- while a stock may go up or down based on market movements, at the end of the day the asset needs to have its own value and propulsion to generate returns.
How to Craft Your Commercial Real Estate Portfolio
After learning the lay of the land, it is time to start building a real estate portfolio. Here are some areas to focus on during that process.
Diversification is Key
Diversification is critical for managing risk within the real estate sector, just like any other investment portfolio. Rather than making a single significant investment in one sector, it is wiser to make a smaller series of investments across sectors. In real estate, both property type and geographic location play a role in how that asset generates returns, so diversification includes both investing in multiple regions and property types. Keep in mind that you do not necessarily need to acquire full buildings, fractional shares in multiple projects, companies, or funds will provide the same diversification benefits- as long as the shares are owned in a wide variety of property types and geographic locations.
The Value of Scaling Up
It isn't enough to diversify your portfolio- realizing maximum gains from a real estate asset portfolio requires a level of care that most individual investors simply do not have the time to provide. This is where professional real estate funds and other managed investment vehicles really shine. The potential returns for specific properties and regions do not remain static- they move with the market. The portfolios with the best projected yields will be able to adjust their holdings by buying or selling assets as needed.
Small-scale investors who sink a large portion of their retirement savings into one or a few buildings expose themselves to risk by not holding a large enough basket of properties. Professional investors like REITs, real estate funds, and others can spread risk over an entire portfolio, with different property types, which are located in a wide range of geographic locations. There is incredible value in large-scale commercial real estate investments, and substantially less risk when compared to small-scale investors who are wholly dependent on one property or market.
There is no getting around it, building a high-performing commercial real estate portfolio is not easy- but nothing worth doing ever is. With a great deal of study and effort, individual investors can generate returns using real estate assets. However, the risk-adjusted rewards for smaller investors suffer from over-reliance on a single property type or region, as well as the inability to take advantage of economies of scale.
For the majority of accredited investors, pooling capital through a REIT, investment fund, or crowdfunded real estate deal allows them to grab hold of the diversification and scale benefits mentioned above, without having to deploy the substantial capital investments usually required of diverse commercial real estate portfolios.