Asset Diversification A Key Part Of The Portfolio Puzzle
Asset diversification is a risk minimisation strategy that is recommended for investors to ride out the ups and downs of different markets. It applies to all asset classes – including property. This article will explain how property investors can diversify their portfolio and why asset diversification within a property portfolio is an important consideration to adopt for a successful holistic investment strategy.
Diversify by property investment strategy
Property is typically regarded as a “growth” asset that has the potential to deliver high returns over long-term investment time frames. Property investors can diversity by Strategy by having a mix of properties that deliver capital growth, cashflow and value add opportunities such as renovation or development potential.
When investors are seeking to build wealth, they tend to have an appetite to build a property portfolio quickly. This requires careful consideration of what strategy might be best to deliver the desired long-term results.
Many residential investors will focus on long-term capital growth as their primary wealth creation strategy. This is a fairly low-risk strategy, and for people with good serviceability, it presents as a safe way to build out their asset base during their younger years.
For other investors who may be on lower incomes, cashflow investing can become more important. In the current lending environment, the opportunity to purchase a property that has a neutral or positive cashflow is increasing, which presents opportunities for investors to get into the market even if their serviceability is somewhat limited.
Investors with a higher risk tolerance may also look towards more aggressive equity-building strategies such as renovation or property development to accumulate wealth across a shorter time frame. These strategies typically involve higher risk, but for those who have the capacity and appetite, they can also carry greater potential return.
Determining which strategy is right for an individual investor at a particular point in time involves careful consideration of personal circumstances including investment goals, the investment time frame, risk appetite, and lifestyle considerations such as an investor’s income and living expenses.
Diversify by asset class
Property has a number of different asset classes including residential, commercial, industrial and retail. Residential property is the asset class that typically comes with the lowest risk, and it is also the most common asset class that property investors turn to when starting out.
As property investors approach retirement, their allocation to different asset classes often becomes more relevant. From a cashflow perspective, residential properties will generally provide a lower rental return than commercial assets. This is due, in part, to the high proportion of costs borne by residential landlords, with owners usually being responsible for ongoing expenses such as maintenance, rates and land tax.
Diversification to improve cashflow often results in investors exploring commercial property as an investment option because typically yields are a lot more attractive. The value of commercial property will largely be based on the income returns they provide to investors. The higher yield of commercial properties, which typically range between 7-9%, is largely due to the fact that commercial investors are able to pass on their rental outgoings as part of their rental rates, with tenants typically responsible for expenses such as land tax, council rates and maintenance.
Property Investors with higher risk appetites often explore investment into commercial, retail and industrial properties. These asset classes do come with the potential for higher vacancy (which is one reason why they are higher risk) but they also have the potential for much higher returns, and therefore careful consideration needs to be given to an individual investor to determine if diversification through asset class is appropriate.
Diversity by geography
Possibly the easiest way for many investors to diversify their property portfolio today is by location. There is not one Australian property market and in fact, there are hundreds of smaller property markets all at different stages of the property cycle around our country.
While they are all driven to a large extent by macro drivers such as access to funding and government policy, it is the micro drivers that really determine how a local property market is going to perform. The local economy, jobs, population growth, and lifestyle elements all contribute to local demand for housing while building approvals and commencements, the availability of land and listing volumes can determine what the local supply is likely to be in the short-term and longer-term years ahead. When there is an imbalance, there is often price change (either up or down depending on which way the pendulum swings).
Concentration risk can come if an investor’s portfolio is restricted to one location, so often the easiest way to diversify and minimise risk is by looking at opportunities in different geographical locations.
When is the right time to diversity within property?
Although real estate investments are often held for years this doesn’t mean portfolios can’t change. Investors who understand what they want to achieve can reduce property investment portfolio risk and boost returns through diversification at any time by re-balancing their real estate investment portfolio. But getting the investment strategy right upfront is often the most cost effective way to build a successful portfolio. Transaction costs are high, which can often be prohibitive to a restructure, but on a case by case basis, often the opportunity cost of holding on to underperforming assets is not worth it.
Diversification is one of the main ways real estate investors mitigate risk and boost returns in a property investment portfolio. Before diversifying a portfolio, investors should have a clear idea of what their short- and long-term investment goals are as well as their risk appetite and investment time frames. But understanding the different options available for diversifying a property investment portfolio is the first step towards planning and building a portfolio that will minimise the volatility of investment returns and perform well over the longer term.