Portfolio diversification happens when assets are managed such that they don’t all react to a given stimulus in the same way at the same time. When one asset goes down, another asset is expected to go up. This offsets all or part of the loss.
They don’t all go up together, but neither are they supposed to collapse in unison. This is considered a good thing.
Investors
The discovery of diversification is not a recent event. The Babylonian Talmud, begun a century or two after Boudicca’s rebellion, when Caesar’s Legions still occupied a large part of Britain, suggests diversification by asset classes: (i) real estate, (ii) business, and (iii) cash. This is consistent with advice that might be offered to long term investors, those who hold assets for over one year.
A millennium or more after Boudicca, Shakespeare wrote The Merchant of Venice. Early on, in Act 1 Scene 1, he has Antonio explain, “My ventures are not to one bottom trusted, nor to one place, nor is my whole estate upon the fortune of this present year, therefore my merchandise makes me not sad”.
Speculators
Notice that Shakespeare makes no reference to asset classes. Diversification, to him, is by (i) means of transport, (ii) location, and (iii) time. Pretty clearly, Antonio is possibly a businessman, or more likely a speculator in commodities. He is probably not an investor.
Antonio diversifies through having his goods transported on more than one ship. Any given ship could be lost to storms, to pirates or mutiny, or even to a misplaced astrolabe (before there were sextants, there were astrolabes). Safety, to Antonio, is found in transporting commodities on many bottoms. It would indeed be a dark day if an entire fleet of merchant ships foundered.
Antonio also diversifies by location. This almost certainly refers to the different ports where the wares already purchased might now be sold.
And he diversifies by time. One sends Christmas trees to Germany in November, not in June.
There are classes of assets that are indistinguishable one from another.. Such assets are technically called “commodities”. Ezra’s Illinois cornfield produces a grain that, when mixed in a barrel with Mort’s Indiana corn, cannot be told apart. Although technically different assets (Illinois corn vs Indiana corn) Ezra and Mort compete directly with each other because dry corn is a commodity. It is functionally the same, wherever grown. It is a commodity.
Apartments
Susan is an investor. She owns an apartment building on Apple Street, just across from the school. The Apple Street property contains only three-bedroom units. With home prices the way they are, that building has a waiting list of young families who can’t wait to move in.
She also owns a property on Berry Street that has only singles (living room, kitchen, and bath). Some of the units are occupied by teachers from the Apple Street school, but most are rented by nurses from the nearby hospital.
Susan has diversified, perhaps accidentally, into a barbell property portfolio. She has desirable family style units near the school that accommodate families and cute, but cheaper singles near a large employer. Those units cater to single people who are weary of living with room-mates.
If she wished to diversify further she could find another fee simple apartment building in a different town. There’s nothing surprising about that. She would simply be repeating her successes. But that’s not her only choice. There are other ways for a property owner to diversify. One way is through a Real Estate Investment Trust.
These are companies that own and manage one or more types of income property. Owning an interest in a REIT (rhymes with “Beet”) is as simple as buying a share of stock. The web page of REIT.com explains that “Real Estate Investment Trusts are companies that own or finance income-producing real estate in a range of property sectors.”
REITs are total return investments in that the stockholder would benefit from both asset appreciation at sale and cash flows during the holding period. In terms of cash flow, REITs are required by law to distribute at least 90% of their taxable income to their shareholders annually.
The REIT industry recognizes over a dozen specific sectors, including not only apartments and offices, but also gaming, timberland, resorts, data centers and telecommunications. Additionally, there are also diversified REITs which own a mix of property types.
If Susan wished, she could further diversify her current two-building portfolio by adding shares in one or more REITs. She currently has a fee simple ownership in the Apple and Berry Street apartment buildings, but sometimes she is drawn towards selling them and buying shares in a REIT where she has no management responsibilities. Perhaps light industrial, or self-storage. The management will be handled by the REIT.
REITs might be appropriate even for the investor whose entire rental portfolio is otherwise located on a few nearby streets near her home. With REITs, she might easily diversify in a manner approximating to that referenced by Babylonian Talmud, by placing a portion of her REIT money into various asset sub-classes of income real estate (examples: apartments, NNN freestanding retail, light industrial, office building, timberlands etc., etc.) that her advisor thinks best.
Alternatively, she could piggy-back on Antonio’s approach and invest in REITs for the non-asset class diversification possibilities. She might, if she wished, purchase shares of REITs, whose assets are concentrated within several fast growing states. Many investors consider the greater freedom of choice that investing in REITs can offer to be a sound reason to at least consider their purchase.
This article is for informational purposes only and is not intended as professional advice.Klarise Yahya is not a financial planner. Nothing in this article is presented as investment guidance. For specific circumstances, please contact an appropriately licensed professional.
Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate, perhaps Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].