There is no sure thing in investing and that includes real estate. Performing appropriate diligence, buying at a good price, and picking a good sub-market and location is all part of successful real estate investing. However, all things being equal, would you rather use $100,000 in order to buy one rental property or use that same $100,000 to invest in a series of publicly-traded REITs and private real estate investments? To me, if it was not clear beforehand, the answer is clear to me after thinking about risk and performance during the current economic slowdown.
Diversification in real estate actually reduces risk
I have talked about how with stocks when the shit hits the fan almost the entire market gets hammered. See here. We saw this in March. Over time, some sectors and individual companies perform better than others but stocks in general are highly correlated to each other when big events happen like a global pandemic.
On the real estate side of the equation, real estate properties and sectors can perform very differently during economic downturns. Therefore, diversifying your real estate portfolio can hedge against significant losses during different economic conditions. Diversification means (1) the type of real estate you own and (2) the number of tenants that support your real estate investments. Think about if you had one investment property in the retail space right now or one rental property that has a tenant that list his/her job in March – you are likely sweating it.
You need to be diversified with the type of real estate you own
To make a long story short, if you owned retail investments like shopping malls you likely are getting killed on those investments and your investment principal might be at risk if that investment is too levered. If you own industrial, office, or multi-family you are likely doing much better. Things could (and likely will) get worse in May, June and July for every real estate sector but April 2020 numbers for many real estate sectors performed admirably in the face of staggering and growing unemployment numbers and a general tanking of the economy.
A recent survey by the National Association for REITs showed the April 2020 rent collections varied significantly by real estate sector:
- Industrial was the strongest performing sector with 98% of April 2020 rents collected.
- Manufactured home REITs were able to collect an estimated 97% of their typical rents collected in April 2020.
- Multi-family apartment building collections were around 93%. This compares with historical averages of about 95-96% in 2019.
- The office sector’s April rent collections were relatively strong at 93% of rents, but there was a lot of variation within the sector. For example, publicly disclosed April 2020 rents collected ranged from 69% to 99% of rent owed.
- In the retail sector, there are three sub sectors, shopping centers, regional malls, and free standing.
- The free standing retail subsector collected an estimated 70% of typical rents collected in April 2020. Many free-standing tenants are essential services like grocery stores, drug stores, or banks which are a stabilizing influence for the subsector.
- Shopping centers collected an estimated 47% of typical rents collected. Tenants providing essential services in shopping centers acted as a buffer.
The take-away: Do not own just one property type when you are investing in real estate. Even though industrial and manufactured housing are performing well many of these assets are priced high and could see pull backs when things normalize. If you only owned retail coming into this crash you are crying yourself to bed right now but in a few quarters it might be time to invest in those properties if the selling price is low enough. I am overly allocated to multi-family housing (yes, I admit it) and I will be looking to add other sectors to my portfolio when the sale prices show greater distress. You should also be thinking about how to best diversify your real estate investments among different property types if you already haven’t done so.
There are plenty of ways to adequately diversify your portfolio among real estate sectors. You do not need to have millions of dollars to do so.
- Public REITs are often focused on specific real estate sectors. Personally, I own several REITs that focus on multi-family properties but I also own a REIT that focuses on office buildings and I just bought some shares of a REIT focused on retail. The retail REIT has seen its share price go from $138 per share to less than $50 per share so I was willing to place some money into this stock because it owns malls in great locations and it has a strong balance sheet for the sector. I am only buying best-in-class REITs with strong balance sheets but there are different options in every sector for you to consider.
- Real estate crowdfunding platforms offer diversified real estate funds that own a mix of property type or you can invest in specific deals and over time if you purchase 10-20 deals among different sectors this should diversify your portfolio. I am not investing in diversified funds through crowdfunding but instead investing in specific deals I find attractive. You can see here why that is the case. However, I have limits on how many deals in one sector or region of the country. For example, I have invested in several different multi-family apartments but I also have invest in a series of medical office buildings focused on recession resistant services and a portfolio of manufactured housing with a sponsor that has a track record of strong performance. I think crowdfunding can be a great way to get access to real estate deals usually reserved for institutional investors but you need to do your own diligence to make sure the assumptions are realistic. Do not take the projections of any deal at face value. Not all deals and not all platforms are created equally.
Increasing the number of rental units within your investment portfolio also reduces risk and costs
I am glad I paid attention to my class in statistics
Statistics in college taught me that if you have a large enough sample then your results should basically reflect the average. For example, if you flip a coin 10,000 times you would expect to get heads about 50% of the time. However, a small sample can vary a lot in its results. Flip that same coin only 10 times and you could get a lot of different outcomes including even 0 or 10 heads. Averages are your friend in real estate if you have a large enough sample size.
Let’s take rent collections with apartments. The April 2020 average rent collection rate for apartment buildings was 93%. That is a pretty good number and most properties can pay their debt and other expenses if rent collections are at 93%. Most can even distribute cash to investors with that collection rate.
Now, if you only a handful of investment properties then you may get a much different collection rate. Like a lot of small investors you may only have one rental in your area that you own. With one tenant you are going to either have a paying or non-paying tenant. Some non-paying tenants may half-pay if you work with them but that is still three outcomes, no rent collected, half the rent collected, or typical rent collected. You are not going to get to a 93% collection rate with one tenant. When a recession like the one we are in hits the probability of getting a non-paying tenant goes up and if it is your one tenant than your collection rate goes to 0%.
I own a single family investment property so with my coin flipping scenario each month I only get one flip of a coin. If the tenant does not pay my rental property goes cash flow negative and in a meaningful way. And it is getting riskier right now. To quote my property manager, “The tenant paid this month but in the wake of this pandemic, we have been lucky, and we we never know what next month will bring.” Not exactly the most comforting information to rely upon. I am significantly cash flow negative for the month if my tenant misses his rent. In fact, one month of missed rent wipes out almost a year of my positive cash flow.
I get a lot more coin flips with the publicly-traded REITs and crowdfunding private investments that I own.
My largest publicly traded REIT position is Equity Residential Properties (EQR). It owns 306 multi-family apartment buildings and approximately 80,000 apartment units. It collected 93% of rents in April. My statistics class was right.
With several of my individual investments in apartment buildings, which have 300-500 units, April rent collections were approximately 90%. I have invested in funds that, collectively, own properties that own about 2,000 units and so my rent collections for these investments should be close to the average. 93% v. 90% is close.
Simply put, my biggest risk regarding rent collections is my single family rental property where next month could come up tails and my cash flow goes to about $2,000 negative per month. I hope it does not happen but either way it is a lesson learned for me.
Now, someone could argue that the safest real estate investment right now is the free standing retail property that houses a Costco, Walmart, or Kroger’s. I would not disagree but all this means is that your single investment bet turned out to be heads this time around. You still had one flip of the coin but the odds improved when everyone had to stay-at-home. That is not a great strategy for me to rely upon. I would rather go with investing based on probabilities.
Another side benefit to owning multiple units – Economies of Scale
I majored in economics and we learned that in many industries the cost per unit to make something goes down significantly as you make more something. The classic example to show economies of scale was some kind of product like a widget (I have no idea what a widget is but that is not the point). For those of you that never made it to your economics class, “economies of scale” is basically the ability to spread out fixed costs among more units and to reduce variable costs with more purchasing leverage.
The important thing here is that this economic principle applies to managing properties. I have no leverage with my property manager that manages my single family rental and therefore my property management fee is a standard 8% of gross rents. There is no negotiation – she is considered a very good property manager and she has plenty of business if I decide not to take her rate. The same goes for plumbers, carpenters, etc. They give me the retail rate and sometimes I can get them down but other times I cannot.
On the other hand, property management costs get to be significantly below 8% of gross rents when you have a lot of units to defer costs. Many of my private investments that own multiple properties or units have property management costs below 3% of rents. The larger sponsors also have the ability to reduce costs related to maintenance and capital projects so they can do more with every dollar of rent that comes in. Managing properties is a classic example of economies of scale at work.
Bottom line, if done correctly, by investing in multiple properties (meaning more units under management) then you reduce risk and also reduce things like per unit management costs.
- Consider how you want to invest in real estate as you build your portfolio of assets. The answer is not necessarily buying that first rental property.
- REITs and private investments through crowdfunding that allow you to invest in multi-unit properties or a portfolio of properties have a lot of advantages which are evident in market downturns like this one.
- Instead of becoming an expert on every aspect of real estate by directly owning that one rental property and performing every aspect of property management – you can focus on becoming an expert on doing due diligence on real estate investments that meet your investment criteria and then benefit from others managing the properties you decide to invest in.