Greg brought me on with the quote, “I think you would be a good counterpoint to Jeff Brown.” Well, I guess its time for me to start earning my keep. I fall on the opposite side of this diversification issue. The benefits of diversification outside and inside of real estate clearly outweigh the incremental positive returns because of the volatility. Additionally, I feel like Jeff and some readers make a mistake when they reflect on the past to judge whether diversification is a benefit or a negative. Hindsight is always 20/20. The purpose of diversification is to limit risk, while maximizing the return for that risk. To look at any one specific past example is not to look at diversification, but to look at one point along a timeline of investing. Diversified investments over time have proven to be better because of the elimination (or minimization) of specific market/property risk.
Here is a quick example. If you own two apartment buildings in similar areas but different location you have the same risk for each location. However, when considered together the investments are far less risky than one building of their same size. The same principles apply in stock investing. Thinking about the Sharpe Ratio, it is very easy to see why this is the case.
As an investor I have always specialized in one asset class, residential (mostly apartments). Recently, however, in the search for Internal Rate of Return (IRR) and diversification I have considered changing course. With so many investment alternatives in the market, I would like to briefly talk about the positives and negatives of asset class specialization. I want to say in advance that I am certainly not an expert in this subject, so I welcome any comments or rebuttals to any statements made here.
First, I decided to specialize in one asset class because I wanted to build an expertise. While I certainly don’t know all there is to know about buying commercial residential properties, I do know exactly what to look for when evaluating an investment. Additionally, I have a lot of experience dealing with tenants, particularly low income tenants. This has served to be a great competitive advantage. Furthermore, I have good local connections in several areas from a deal sourcing and contracting perspective.
Recently I have been considering the synergies of this asset class and others. For example, there is a good opportunity in the mobile home space to get a good return in a few areas in Greensboro and Detroit. With a structure similar to apartments, I thought this might be a good first investment for diversification. However, upon looking at tenants and cash flow structure, it seems that these investments are a bit too similar and really provide no diversification benefits at all.
Additionally, I have considered whether the need for diversification among asset classes really exists. Can I be diversified if I own apartments in different locations for example? The answer to this question is mixed. While this one kind of diversification can offset a specific market shock, the general economy would still have an effect on the asset class overall. Think about macroeconomic factors like interest rates, job growth, and housing starts. While interest rates typically have a country wide effect, job growth and housing starts are a national stat with very local impact. National job growth could be strong, but markets like Detroit could still be feeling significant contractions. All of the housing starts could be in major markets, with many minor markets (or even mid major markets) still experiencing high absorption rates.
Then, throwing risk into the mix and the diversification picture gets even cloudier. Apartments tend to be the lowest end of the spectrum, while assets like office, retail, industrial, and hotel move to the upper end. Assuming that the returns compensate for the risk, I expect the riskier assets to give me a higher return. Since I am an apartment investor, I have become very accustomed to a certain level of risk. One of the biggest issues with changing asset classes involves changing expectations and risk tolerance. This goes both ways. If I am an apartment investor, now branching out into office or retail I should expect higher vacancy on average, but also a higher return on average. Similarly, if I am a hotel operator, who wants to now invest in condos, I should expect lower vacancy and lower returns. Not rocket science, yet.
Lastly, asset class diversification would assume that all investments are equal given the risk return scenario above. Unfortunately that is not true because of the expertise factor. While I may be great at selecting low income tenants for my apartment building, I have very few connections with corporations looking for office space. I would be like a fish out of water trying to fill buildings, negotiate leases, figure out tenant finish allowances, and generally trying to run the building. I think this is the catch to asset class diversification. Larger companies can invest across many asset classes (though many don’t) because they can hire experts for each class. However, smaller investors, like me, may have an expertise at one or two classes and their close cousins. It takes years to build relationships and connections in an area and an asset class. While some skills are transferable across all asset classes, many skills are unique.
I want to close with one more push for diversification. Real estate is one of many asset classes an investor has to choose from. The shear amount of diversification opportunities that exist in and out of real estate almost make it inexcusable not to diversify. Everyone can think of a time where diversification hurt them, but how many more times has it helped you?
David Saks says:
Also, advertising your locations is a bit more complicated with residential than commercial property. In a strange way, it figures into the math. You can’t just place a for rent sign on the window ledge in an apartment complex. Enjoyed your article.
January 24, 2007 — 3:13 pm
Jeff Brown says:
Michael – Excellent post.
My diversification argument is based on the industry vs industry approach as opposed to intra industry. I have no problem with ‘hedging’ the trapese act on one end of the RE spectrum with a relatively conservative approach on the other end. 🙂
Whether an investor has the expertise to profit equally from residential and commercial real estate is the crucial factor (or should be) in his decision to venture into the new sector.
I decided years ago, with only three exceptions, to stay away from the office & retail market. There have been several times the owner of a retail or office building could’ve offered to give their tenants a nickel a foot to stay, and the tenant still would have closed their doors. But many of their employees went home to my apartments. I know investors make a ton on that side of our business, but it’s too profitable on the residential side to mess with the increased risk for me.
Although contacts certainly can make your life easier, they’re not required for long term success. The principles you have used to get where you are today are not based on your many contacts, but on your high skill level, market knowledge, and plain old guts.
If I limited myself to areas in which I had many long term contacts I wouldn’t have made significant hits in both Phoenix and Boise. I knew literally nobody when I got off the plane for the first time in both cities. I simply applied the same principles you have, and didn’t deviate from what I knew. Profits followed.
It’s my contention we could drop you into any sizeable American city, and you’d make money because you know what you’re doing. You’d locate your ‘contacts’ by trial and error.
When I was your age I thought I had your knowledge and expertise, when in fact back then I couldn’t have carried your jock. 🙂 Welcome to Greg’s circus of alpha dogs.
January 24, 2007 — 4:05 pm
Chris says:
Excellent post and an interesting counter point. Good food for thought.
I view intra industry “diversification”, as more of a hedge against a downturn. Say you invest strictly in apartment buildings and own several all in different areas of the country. To me that would be a hedge, vs owning a couple all in the same town or city. Certian regions are affected differently, so by spreading out your holdings you hedge against this. You could make this argument with any form or RE.
Excellent site, you guys really know your stuff! Way more advanced then I am.
January 24, 2007 — 8:56 pm