• How to Enhance Portfolio Diversification Using Real Estate

    From a425couple@21:1/5 to All on Tue May 7 14:35:22 2019
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    from https://fundrise.com/education/blog-posts/how-to-enhance-portfolio-diversification-using-real-estate

    How to Enhance Portfolio Diversification Using Real Estate

    All investment portfolios – even the strongest – are likely to hold investments that will experience some periods of loss. However, by
    diversifying your portfolio holdings, you can mitigate those losses,
    which can boost your portfolio’s return potential. But not all diversification strategies are created equal, which makes choosing the
    right diversification strategy crucial to your investment success.

    Most investors understand the risk that comes with investing in a single
    stock, asset type, or industry. But what about the risk that comes with investing in only one market? Many investors are diversified across and
    within asset classes, sectors, industries, and more – but, usually all
    within the stock market, which is a public market. With the public
    market shrinking, and ownership of stocks becoming more consolidated, investments traded in the stock market are becoming increasingly
    correlated. With this, meaningful diversification is getting
    increasingly difficult to achieve in the public market alone.

    Wider accessibility to private market investments offers individual
    investors new options outside of the stock market. Private market real
    estate, in particular, is far more accessible now than it has ever been.
    Easy accessibility, together with the benefits of low correlation with
    the stock market, a history of long-term appreciation, and the potential
    for regular income, can make real estate a powerful diversifier for your portfolio.

    Jump to
    What Make an Investment Portfolio Diversified?
    The 20% Rule
    How Real Estate Can Enhance Portfolio Diversification
    How to Diversify into Private Market Real Estate
    Evaluating Your Options
    What Make an Investment Portfolio Diversified?

    Diversification is used to reduce the risk of loss, which ultimately can improve the stability and return potential of an investment portfolio.
    When risk is reduced properly though diversification, its volatility is reduced. With lower volatility, an investment portfolio is more stable,
    and its return earning potential more predictable. Rather than being
    forced to ride the waves of market cycles, investors are able to enjoy
    the peace of mind that comes with having their investments live on
    quieter waters.

    So, what does a diversified portfolio look like?

    There are many diversification strategies to choose from, but strong
    ones generally try to maximize a portfolio’s risk-adjusted returns. In
    other words, you should try to invest in assets that offer the highest
    possible return at your given risk level. By investing in assets with
    low or no correlation, you can reduce unnecessary risk in your portfolio.

    When investments are correlated, they share some or all of the same set
    of risks. So, if one investment experiences a loss, then a correlated investment is also at risk of loss. On the other hand, if your portfolio holdings are spread across uncorrelated assets, the performance of one
    or more investment could mitigate losses in your portfolio when another
    asset underperforms. This is because uncorrelated assets are far less
    likely to lose value in tandem than correlated investments.

    The 20% Rule
    The 20% rule is a leading diversification strategy, which was created by
    the Chief Investment Officer of the Yale Endowment, David Swensen. The
    20% rule aims to reduce portfolio risk and in turn maximize return
    potential by allocating at least 20% of an investment portfolio toward alternatives – an asset class with low or no correlation with
    traditional, publicly-traded assets. Alternative investments are
    investments that fall outside of the classification of traditional
    investments, and are generally traded in the private market. Following
    the 20% rule, private market investments are becoming increasingly
    crucial to investment success. Institutional investors have a longer
    history of diversifying into alternative with pensions and endowments allocating 28% and 52% of their portfolios respectively to alternatives.

    investment-portfolio diversification-20-percent-rule

    How Real Estate Can Enhance Portfolio Diversification
    The private market experiences very different buying and selling
    dynamics than the public market. Let’s look at the attributes of private market real estate and how this asset class can be a powerful
    complementary diversifier for a portfolio of traditional investments.

    Separate Markets with Low Correlation
    The biggest difference between private market real estate and
    traditional investments is that they trade in different markets.
    Traditional investments, such as stocks, bonds, and commodities, trade
    in the stock market, whereas private market real estate trades in, as
    you may guess, the private market. Public market investments each have
    their own individual sets of advantages and disadvantages, but because they’re traded in the same market, they share the same marketwide
    strengths and weaknesses. And, because private market investments are
    traded in a separate market subject to different driving forces and
    structural features, they don’t share the same wide risks as public investments. Therefore, private market real estate has a low correlation
    with traditional investments at the market level.

    For instance, expectations of future interest rate hikes (or actual
    hikes) typically cause the stock market to decline, because higher
    interest rates can reduce both business and consumer spending.
    Similarly, expected or actual rate hikes can have a depressing effect on publicly traded real estate investment trust (REIT) share valuations,
    because higher interest rates reduce the risk-free to capitalization
    rate spread thereby driving down real estate values.

    By contrast, expected or actual shifts in the interest rate environment
    should have minimal impact on an investor’s equity stake in a commercial
    real estate asset as long as the senior debt financing secured for that investment is a long-term loan with a fixed-rate. In fact, an interest
    rate hike could make the asset more valuable, because it now offers an
    interest rate hedge, and stands to benefit from the likely positive macroeconomic market conditions that typically precede federal interest
    rate hikes.

    Distinctive Investment Structures by Market
    Coupled with low correlation at the market level, the performance of
    private market real estate has a low correlation with the performance of
    public market investments at the asset class level. Although real estate
    is traded in the public market through REITs, private market real estate investments are structured in a wholly different manner. REITs
    themselves are structured differently in the private market, whether
    private REITs or public non-traded REITs, which gives REITs different diversification potential based on the market in which they’re traded.

    In general, these different structures carry different sets of risks,
    fee structures, return structures, and varying return potential.
    Therefore the differences in investment structures between public and
    private market vehicles further reduce the correlation between private
    market real estate and traditional investments.

    Differences in Access to Liquidity
    One of the biggest benefits of public market investments is the high
    level of liquidity that they offer. Shares of stocks and bonds can
    easily be bought and sold on a daily basis. Because of this, public
    market investments offer a high degree of flexibility.

    However, it’s important to note that this access to daily liquidity
    comes at a price. The liquidity premium is a built-in cost, which is
    innate to public market investments. Investors pay whenever they buy an investment. For long-term investors who follow the “buy-and-hold”
    strategy, this can be an expensive feature that goes largely unused.
    Those who are building a portfolio to support their retirement plan are
    usually long-term investors, who should likely lean more toward
    long-term investments. Avoiding costly features that go mostly unused
    while building the most stable and reliable path to retirements saving
    possible are key.

    Private market real estate, on the other hand, is generally illiquid
    with return potential maximized over time through rental income and/or appreciation. Liquidity options for both public and private investments
    each have their advantages and disadvantages, but their differences can
    make private market real estate a good fit for long-term investors, as
    well as powerful complementary diversifiers for investments with shorter investment horizons.

    Market Efficiency Mean a Lot for Investors
    The public market is highly efficient with prices set by the market. Information concerning public investments is widely disseminated, which
    makes it difficult for one party to gain more information than the other
    party on an investment. Transaction costs are also low, which results in
    more frequent buying and selling. In fact, more than a billion shares
    are publicly traded each trading day.

    In contrast, the private market is highly inefficient. Buying and
    selling private market real estate generally comes with higher
    transaction costs, and with fewer buyers and sellers participating.
    These differences in buying and selling dynamics in the private market
    offer another diversifying element for investors largely invested in the
    public market.

    While these conditions may seem unfavorable, they are actually
    potentially more favorable to investors. That’s because whereas the
    market sets prices in the efficient public market, there’s room for negotiation between the buyer and seller in the inefficient private
    market. With fewer buyers and seller participating in the market, and
    with information unequally shared, the market doesn’t necessarily set
    the price of the asset, giving investors a greater chance to “beat the market” in a way that isn’t possible to do on a consistent basis in the public market.

    Essentially, limited competition on the buyer’s side in private markets
    gives those with the necessary knowledge, skills, and resources a
    competitive advantage to earn above-market returns, or alpha. An
    investor who holds common stock in a publicly-traded company doesn’t
    have the ability to earn outsized returns because they have more
    knowledge, resources or skills than another common-stock holder. An
    investor could spend hours daily researching Apple, but this would
    likely not change their return potential from their Apple shares. In
    other words, your returns will be the same as those earned by any other shareholder with the same class of stock who buys and sells those shares
    at the same time.

    Build a more perfect portfolio. Get started here.
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    How to Diversify into Private Market Real Estate
    There are several ways to diversify into real estate in the private
    market, each of which requires different amounts of time commitments, expertise, and money. Broadly speaking, real estate investing breaks
    down into two categories: active and passive.

    Active Investing
    Active real estate investing for individuals includes options, such as
    rental properties, and house-flipping. Return potential for each of
    these options is limited to rental income and appreciation. These
    methods typically require a significant amount of personal knowledge of
    real estate, and hands-on management or delegation to experts, who can
    come with hefty fees. Additionally, large upfront capital commitments
    are required for the lifetime of the investment.

    For example, if you buy a rental property, any money that goes toward
    buying the home in the form of a down payment or mortgage payment will
    be tied up in the property for the duration of the lifetime of the
    investment. Only upon selling can you access your principal and any appreciation that you’ve earned.

    House-flipping is typically completed in a shorter timeframe than a
    rental property – typically a long-term buy-and-hold strategy – but it
    also usually comes with a lot more responsibility and risk. It requires
    an investor to add value to the home at a given budget in order to be
    able to sell it at a profit within a given timeframe. Any missteps can
    reduce or even eliminate return potential.

    Diversification Potential

    Because active investments typically require large capital commitments potentially for long periods of time, it’s usually difficult for
    investors to diversify within the asset class by investing in multiple
    active investments at once. By investing in only one or a few active investments, risk among those few investments is concentrated. Active investments are subject to the same market and asset class risks. And
    because investors typically invest locally, they’re subject to the same geographic risk.

    For example, if a rental property requires unexpected repairs, or sits
    empty for several months at a time, as the only one or one of the few
    active investments held by the investor, the investor will suffer a
    large loss. And as the sole owner of the investment, he will bear the
    loss entirely.

    Passive Investing
    Passive private market real estate investments are closer to what’s
    found in public market investments. As in the stock market, passive real
    estate investors typically provide only capital and allow professionals
    to invest in real estate on their behalf, and passive investors bear responsibility only for their investments. Passive investments usually
    offer investors a portfolio of real estate, which offers greater diversification potential than active investments in a handful of
    properties. And unlike active investments, which earn returns primarily
    through rental income and appreciation only, passive investments can
    also earn returns through interest payments on debt investments. On top
    of these benefits, some passive investment options carry lower
    investment minimums, which offers greater accessibility to investors of
    all sizes.

    Private Equity Fund

    A private equity fund is an investment model where investors pool their
    money together into a single fund to make investments. A designated
    manager or management group usually manages the operations of the fund,
    while investors aren’t required to participate on a daily basis. Real estate-oriented private equity funds typically hold multiple real estate investments at once, but volume depends on the dollar size of each
    investment as well as the investment capacity of the fund.

    Due to the fact that the investment capacity of each private equity fund
    is different, each one offers different diversification potential within
    the asset class of real estate. In order to invest wisely and to
    understand how these investments can impact the risk and return
    potential of their portfolios.

    Access to private equity funds is generally limited to accredited and institutional investors with high net worths. Investment minimums can
    vary, but are usually not less than $100,000. These investments are also generally illiquid. Additionally, private equity funds typically use a
    “two and twenty” model, in which they charge a 2% annual management fee
    and an additional 20% fee on any profits that the fund earns. Due to the
    high investment minimums and fees entailed in private equity investing,
    it is important for investors to have the financial and real estate
    knowledge necessary to understand the risks and potential value of each investment.

    Private REITs

    Like public REITs, a private REIT typically offers a wide portfolio of
    real estate investments. By law, a REIT must earn at least 75% of its
    gross income from real estate and invest at least 75% of its assets in
    real estate. Additionally, it must distribute at least 90% of its
    taxable income to shareholders each year.

    Private REITs are similar to private equity funds in many ways. They are usually limited to accredited investors, and while minimums are
    subjective, they are usually quite high. Investments are typically
    illiquid, and the REIT structure also generally carries high fees,
    sometimes as much as 15% in the form of upfront formation fees, ongoing management fees and in some cases carried interest fees.

    Due to the similarities with private equity funds, the diversification potential of private REITs varies by each individual REIT. Therefore, in
    order to be able to assess the risk and value of each investment held by
    the REIT, and to determine the impact on an investor’s portfolio, it’s important that investors have the required financial and real estate
    knowledge before investing.

    Build a more perfect portfolio. Get started here.
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    Online Real Estate Investment Platforms

    Online real estate platforms offer a new way to invest in single
    investments or a diversified portfolio of real estate. Some platforms
    focus on debt investments or rental properties, while others focus on
    specific geographic locations. Platforms that limit real estate
    investments by geography or asset class concentrate along those lines,
    which inherently limits their diversification potential. Platforms that diversify real estate investment along the lines of investment type
    (debt, equity) and property type (residential and commercial), as well
    as by geography, stand to offer investors stronger diversification
    potential.

    Investor access can also vary by platform. Some platforms are restricted
    to accredited investors, and others available to non-accredited
    investors can still carry high investment minimums. However, this isn’t
    the case for all real estate investment platforms.

    For example, Fundrise offers access to portfolios of real estate
    diversified across dozens of debt and equity investments, commercial and residential real estate, as well as geography. This provides investors
    with not only exposure to private market real estate, but also critical diversification within the asset class of private real estate,
    potentially reducing risk and boosting return potential. Unlike other restrictive real estate investments, Fundrise is open to accredited and non-accredited investors with a low investment minimum of only $500.

    Evaluating Your Options
    Fundrise is the first investment platform to create a simple way for
    anyone to access institutional-quality private real estate, along with
    its historically consistent, exceptional earning potential, and its diversification power.

    It’s up to each investor to determine which asset classes and
    diversification strategies suit them best. But, no matter how you choose
    to diversify, the traditional barriers that once restricted access to
    useful diversification have fortunately been lowered, giving investors
    the power to construct truly diversified, risk-mitigated portfolios like
    never before.

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