Diversification into a different property type is a great way to limit your exposures, but there are three key things you should consider before taking the leap.
Diversify. Diversify. Diversify. You probably hear it all the time. Diversification is potentially one of the most hyped real estate topics out there. It’s most certainly a strategy with value, but has to be approached thoughtfully and strategically to maximize the advantages.
Put simply, diversification entails adding a different asset class to your portfolio. For most investors, diversification is a way to more evenly distribute exposures to different asset classes in the event that economic unrest affects a specific asset class.
For example, many office investors in Calgary right now are dealing with a saturated marketplace heightened by the falling price of oil. Tenants are hard to find and supply is plentiful. Diversification can help to balance those factors. Industrial warehousing in Windsor is another area where diversification can play a strategic role. When the dollar falls to lows like we are seeing now, exports go up and manufacturing in the area scales. However, if the dollar rises again (which it is likely to), growth becomes more limited.
Popular asset choices for diversification
Apartments: consistent revenue but higher management costs
Apartments are the most popular asset class, and are usually the starting point for most investors. Revenue is consistent as a result of the fact that people are always going to need a place to live. Demand is high, and tenants are relatively easy to replace. If you have 100 units and you have one vacant, you’re only losing a small proportion of revenue per month.
However, because you are dealing with people’s homes and livelihoods, apartments are more management intensive. Units and their tenants require constant and ongoing management. As a result, superintendents or property managers must be constantly involved in the heartbeat of the building.
Retail/Office/Industrial: less management intensive but more revenue risk
Retail/office/industrial assets classes differ in functionality and use from apartments, but the premise is the same. Instead of leasing to individuals as tenants, owners lease to businesses, leveraging regulated and standardized processes.
Those leases tend to be quite complicated, and often require specialized expertise for negotiations. Dissimilar to apartments where owners pay hydro, utility and tax expenses, tenants are responsible for paying those costs. Those parameters must be embedded and clearly articulated in the leases.
With tenants paying the expenses, these asset classes tend to be less management intensive. However, the revenue risk is much higher.
An apartment building with 50 units and a retail asset with four units are roughly in the same price range. When considering one or the other, there is certainly a more negligible revenue loss with apartments. If you have a four-unit retail asset and you lose one tenant, 25 per cent of your space is vacant, and you are responsible for covering those expenses. The time cycles to replace tenants are longer as well.
Four key considerations to any diversification decision
Stay inside your comfort zone:
In most cases, taking risks in real estate is a path to prosperity. However, with diversification, caution is the order of the day. If you own apartments in Toronto, it’s not the greatest idea to buy office in Waterloo. Stick with what you know in terms of jurisdiction, location and market.
Do your research:
Learn everything you can about the asset you’re considering, so you know what makes it successful. Location considerations are critical. Apartments should be close to transportation hubs, retail should be located on busy, main roads and office should be in proximity to major highways. It’s also important to know the demographics of a jurisdiction. For example, if you are planning to secure a tenant specializing in goods and services for babies, it may not do well in a city or area with a more elderly population.
Know the management challenges:
If you are planning to transition from one asset to another, be aware of the management challenges that may arise. Each asset class has its own behaviours and issues. Be open to finding a partner or experts with specialized skills to teach you the ins and outs of the asset and management requirements.
Think, plan and be strategic
Diversification can be a healthy growth strategy and proves to be one for many investors. However, being successful requires investing time and thought. Research. Research. Research. And then research some more. The more time you spend doing your homework, the more confident you will feel that you’re making the right decision.
Partnering is also paramount. Find someone with a lot of experience with the asset class and soak up his or her knowledge and insight. Many investors tackle diversification as a joint venture. In addition, choose the right team of experts – financing, lawyers, leasing agencies, investment pros, realtors. They bring a focused expertise to bare, and together, can help steer you in the right direction.
And remember, diversification is not a short-term strategy. It requires a slow, steady approach that includes thought, planning and strategic thinking.