Commercial Real Estate Diversification Tips For Portfolio

As a commercial real estate expert with over 18 years of experience, I’m often asked by investors about strategies to mitigate risk in their real estate holdings. While past returns are no guarantee of future performance, the data shows that a diversified real estate portfolio stands a better chance of delivering consistent cash flow with reduced volatility over the long term.

Key Takeaways

• Diversification is crucial for mitigating risk in commercial real estate investing. Spread investments across different asset classes, geographic locations, and risk profiles.
• Allocate 10-30% of your total portfolio to alternatives like commercial real estate. Within that, invest in a mix of property types.
• Regularly rebalance your portfolio as market conditions change by taking profits, adding new sectors, and adjusting allocation percentages.

Why Diversify Your Commercial Real Estate Portfolio?

In this blog post, I’ll share my top tips for diversifying your commercial real estate investments across different:

• Asset classes
• Geographies
• Risk profiles
• Ownership structures
• Sponsorship operators

I’ll also discuss some best practices for ongoing portfolio management and rebalancing.

Whether you’re just starting to allocate capital into commercial real estate or looking to diversify an existing portfolio, my goal is to provide actionable advice for mapping out a balanced investment strategy.

Before jumping into the specific diversification approaches, it’s important to understand the key benefits:

• Reduced portfolio risk – Rather than concentrating investments into just one or two assets, diversification allows you to spread the risk across a basket of properties. If performance lags in one area, other assets can buoy returns.
• Exposure to multiple property cycles – Each sector has its own market cycle. Office, retail, industrial, multifamily, and hospitality can peak and trough at different times. Diversifying across them smooths out volatility over long periods.
• Take advantage of sector rotation – As economic and demographic fundamentals shift, new trends emerge while former high-flyers stagnate. Maintaining a mix of property types allows you capitalize on sector rotation.
• Specialized insight – Working with experienced sponsors and operators in each space provides localized market intelligence and specialized expertise that unlocks value.

In general, alternatives like commercial real estate should make up 10-30% of a balanced investment portfolio for high net worth individuals and institutions. But diversification doesn’t stop there…

Ways to Diversify Your Commercial Real Estate Investments

Within your real estate allocation, it’s important to build diversification across these five axes:

Diversify Across Asset Classes

Commercial real estate encompasses a variety of property types beyond just apartments, each with unique demand drivers, risk profiles, and return potential.

A properly diversified real estate portfolio allocates capital across multiple sectors:

• Office – Class A buildings in core central business districts can provide stable cash flow. There is also opportunity in suburban office parks and medical facilities.
• Retail – Malls may struggle but necessity-based retail with experiential elements can thrive. Grocery/pharmacy-anchored shopping centers are less volatile.
• Industrial – Warehousing and distribution centers serving surging e-commerce demand offer strong tailwinds but also come with more geographic concentration risk.
• Multifamily – Apartments benefit from the demand for affordable urban housing but oversupply in certain markets can dampen performance. Developments targeting luxury and workforce renters mitigate risk.
• Hospitality – Hotels and resorts bounce back strongly during economic recoveries but are vulnerable to recessions and event cancellations. Select service and extended stay concepts add resilience.

Balancing exposure across these major food groups helps smooth returns while allowing room to capitalize on sectors with favorable fundamentals. As market cycles evolve, you can emphasize asset classes that offer the best risk-adjusted returns.

Diversify Across Geographies

Beyond diversifying across structure types, it’s critical to also diversify the locations of your property investments:

• Invest in a mix of both coastal & inland cities
• Build exposure across high-growth Sunbelt markets
• Balance large tier-1 cities with smaller regional centers
• Consider global gateway cities to diversify internationally

The key is to mitigate concentration risk in any one metro area while emphasizing markets with strong demographic and job growth tailwinds.

Diversify Across Risk Profiles

Commercial real estate investments also fall along a risk spectrum, ranging from:

• Core – Stabilized assets in primary markets with stable, predictable cash flows. Lower risk but capped return potential.
• Core-Plus – Cash-flowing properties outside top-tier locations. Modestly higher risk with better yield prospects.
• Value-Add – Assets requiring repositioning or renovation investment to improve financial performance.
• Opportunistic – Distressed or development projects with intensive capital needs but far higher returns possible. Much higher risk tolerance is required.

Maintaining a balance of core and higher octane investments allows you to remain anchored amidst volatility while still participating in the upside of riskier bets.

Diversify Across Ownership Structures

Gaining access to commercial real estate opportunities often requires partnering with seasoned sponsors and operators. But you can also build diversity across investment vehicles:

• Direct – For larger deals, you can co-invest alongside an experienced sponsor for 100% ownership of a specific asset. This offers greater control but also concentration risk.
• Funds – Pooling capital with multiple investors provides exposure to a basket of projects and geographies. The drawback is less visibility and control over specific assets.
• REITs – Real estate investment trusts offer a liquid, low-cost way to gain broad exposure. However, returns lag specialized private equity vehicles with value-added strategies.
• Crowdfunding – Online commercial real estate platforms allow investors to deploy smaller amounts of capital across multiple deals. Conduct proper due diligence as quality varies.

Employing a mix of ownership structures expands the range of opportunities while also mitigating exposure risk to any single asset or manager.

Diversify Across Sponsorship

Vetting and partnering with experienced real estate sponsors and operators is key for deal access, especially for direct joint venture investments.

But diversification applies here as well:

• Work with multiple sponsors to avoid over-exposure to a single manager’s dealings.
• Look for specialization across different sectors and markets – leverage localized intelligence.
• Evaluate track records across both up and down markets. Examine the balance of wins and losses.
• Ask about their approach to navigating past sector downturns and how they reposition portfolios ahead of market shifts.

Checking references and past performance provides confidence that your chosen partners can source and execute opportunities while protecting the downside across market cycles.

Best Practices for Implementation

Once you’ve mapped out target allocation percentages across the different diversification dimensions above, here are some best practices for putting your plan into action:

• Phase entry – Given minimum investment sizes, deploy capital in tranches over time instead of all at once. This allows you to average into positions.
• Rebalance annually – Revisit your portfolio mix percentages every 12 months – take profits from outperformers to reallocate into lagging areas primed for mean reversion.
• Listen to the market – Pay attention to macroeconomic trends, property fundamentals, and market sentiment for clues on sector rotation opportunities.
• Invest locally – Combining geographic and sector diversification by working with specialized regional operators and sponsors unlocks localized asset strategies.

Portfolio diversification is not a set-it-and-forget-it undertaking. Adapt allocations as the market changes while following core guiding principles of balanced exposure.

FAQs

How many commercial properties should I own for a diversified portfolio?

Given minimum investment sizes, a properly diversified private equity real estate portfolio can be built over time with 8-12 properties invested across different sectors, risk profiles, and locations. Of course, those with more capital can expand further. Many institutions own private stakes in hundreds of assets.

What is the ideal allocation percentage for commercial real estate within an investment portfolio?

Most financial advisors suggest alternatives like commercial real estate should make up 10-30% of a high net-worth investment portfolio – balanced with stocks, bonds, and other assets. Of that real estate allocation, target spreading investments across 3-5 property sectors.

Which commercial real estate asset classes perform the best over the long run?

Historically, industrial and multifamily rents and occupancy have demonstrated the most resilience across decades. Office and retail properties are more vulnerable to disruption from new technologies. Allocating at least some exposure to the multifamily and industrial sectors can anchor overall real estate portfolio performance.

How can I mitigate risk when investing in commercial real estate?

Diversification is the key to reducing portfolio risk, Forbes even agrees.- across property types, geographic locations, risk profiles, ownership structures, and sponsors. Also, consider recession-resilient sectors like grocery-anchored necessity-based retail and affordable workforce housing. High-quality sponsors with experience navigating across market cycles can also help preserve equity.

What factors should I evaluate when analyzing specific properties?

Conducting thorough due diligence on each potential investment opportunity is crucial – verify ownership titles, inspect for environmental issues, review rent rolls and vacancy rates, examine location fundamentals, assess renovation costs needed, etc. Also, evaluate the sponsor’s reputation and track record executing similar projects. Leverage trusted partners and advisors for the deepest diligence.

Conclusion

With some basic guiding principles, mapping out a diversified commercial real estate investment strategy doesn’t need to be complicated. Spread exposure across complementary assets with cycles that fluctuate independently. Work with experienced and trustworthy sponsors rooted in their local markets. Monitor changing conditions and be ready to rebalance.

If you’re interested in learning more about commercial real estate opportunities, schedule a consultation with me. With over 18 years of experience representing business owners, landlords, and investors, I can help guide you through building a balanced commercial property portfolio tailored to your investment goals and risk tolerance.