March 2018 update: since this article was written in 2015, things have improved dramatically for some investors. Many real estate crowdfunding sites have moved beyond single property investments, and now offer multiple property (pooled) investments.

These allow an investor to very quickly and easily achieve 120+ property portfolios for effective diversification. For example, a single investment in BroadMark hard money loan fund puts an investor in hundreds of properties.

So the information below is no longer pertinent in all cases. However, I'm keeping it here for those continuing to invest only in single property investments (since this is still an issue for them).

The overall direct real estate market has returned an impressive 9.2% + over time, with volatility as low, or lower than bonds. So you might think that any individual investment is fairly safe.

 

Unfortunately it's not so. The phenomenal stability in the averages of hundreds of thousands of properties, hide the unstable volatility in many of the individual properties. That's because there's a laundry list of things that can cause your individual investment's property value and/or income to fall. When that happens, your earnings can dip below average (and/or you may lose some or all of your initial investment).

 

How things can go wrong

 

For example:

 

• Individual property risk (unexpected repairs, unexpected environmental cleanup, etc.)

• Tenant risk (unexpected late payment, unexpected default, unexpected maintenance, etc.)

• Operator risk (unexpected financial issues, late payment, unexpected default)

• Geographic risks: (unfavorable conditions in the local area, metropolitan area, region of the country, or nationally).

• Economic risks: (unfavorable conditions in the current business cycle)

• Property type risk: (unfavorable conditions for commercial or residential property. Under commercial, unfavorable conditions for any of the multitude of niches including: retail, industrial, apartments, public storage, warehouses, medical facilities, malls, downtown offices, suburban offices, etc.)

• Investment strategy risk: (unfavorable conditions for core, core plus, value-added, or opportunistic strategies).

 

The solution: diversification

 

So, it's important to diversify your investments, across multiple properties. When you do that, the effect of a few "bad apples", are negated by all the others.

 

Great. So how many do you need?

 

No single number

 

Unfortunately, I've searched high and low, and cannot find an independent study that answers this question with a single number. (If you know of a study, please let me know!)

 

While we may not know an exact number, it's fairly easy to determine a range for proper diversification. 

 

What do institutional investors say?

 

Institutional investors have been investing in direct real estate for decades. And they like to talk. I found several references to the value of diversifying in institutional research or informational material, that referred to diversification in the 100+ range. 

 

For example, "IFEBP Benefits" (a magazine for benefit plan institutional investors), said:

 

"Real estate managers are expected to minimize the probability and severity of losses due to market risks by diversifying assets across multiple properties (sometimes hundreds), property types, regions and tenants"

 

The quote above is for core investments: which are the most conservative real estate investments, and the ones needing the least amount of diversification.

 

If the expectation for competent core real estate manager is "sometimes hundreds", then the expectation for a portfolio with a mixture of strategies(core plus, value-added, opportunistic), is even higher.

 

 

HUNDREDS OF PROPERTIES!? Really?

 

That's a shockingly high number.

 

So it's a good idea to give it a back-of-the-napkin reality check. Let's quickly calculate the number of properties needed to diversify across just the biggest/most common diversifiers:

 

1. Strategy: 4 (core, core plus, value-added, opportunistic)

2. Region: 5 (Northeast, Northwest, Southeast, Southwest, Midwest)

3. Asset type: 6 (office, retail, apartment, industrial, residential, other)

 

4 x 5 x 6 = 120 properties. 

 

That's a minimum and doesn't include other types of diversification that you might choose as necessary. 

 

1. If you felt it necessary to diversify across the two investment types (debt and equity), that would take 240 properties.
    

2. If you feel there's too much diversity in the above regions to properly eliminate geography risk, there's a good argument for splitting each region into two smaller subregions, which would again require 240 properties.
    

3. Meketa Investment group says that the minimum requirement for diversification includes the vintage year (to eliminate the significant market cycle risk that real estate has).
   
   Personally I don't explicitly diversify this way, because I'm very active and keep on top of the market cycle. But a passive investor would definitely benefit from this type of diversification. Doing this would require a portfolio in the hundreds of properties.

 

But whether those factors are considered are not, the range is from 120 to "hundreds". Our back-of-the-napkin reality check, matches that of the institutional investors. 

 

The big problem for the industry

 

If this is true, the real estate crowdfunding industry has a big problem. The current minimums are too high to allow the average investor to properly diversify.

 

I'll talk more about this in part two of this article: "Site minimums put diversification beyond average investors' reach?".