Multifamily Portfolio Diversification: An Example

Presented by Andrew Gaines

Diversification is basic risk management. This means constructing a portfolio by spreading investment capital across different types of investments with a positive expectancy. In this way an investor is more likely to achieve positive returns over the long run. Every investment has risk.  We want to construct a portfolio that avoids concentrating too much capital in any one type of risk. Implementation of appropriate diversification involves, first, identifying the relevant risks for each investment.

 In the multifamily context, there are four factors that I would highlight for consideration. Each factor represents a risk that can be effectively managed by diversification.

Operator/General Partner

 The general partner in a multifamily syndication is the entity that develops and implements the business plan for the investment property.  This group manages the day-to-day developments on site and strategically deploys capital into the property to execute the business plan to increase the assets value.  The operator makes mission critical decisions that, to a large extent, determine the overall success of the investment project.  It is clear that selecting an experienced, capable general partner is vitally important, because even the best operators may experience ebbs and flows in the performance of their projects over time. Operator risk can be managed by spreading our capital allocations across at least a few different operator groups.

Geography

 You are familiar with the real estate dictum that the most important elements of any real estate deal are “location, location, location.”  This is a critical factor and carefully considering where one allocates capital is essential.  Cities and state experience the cyclical dynamics of growth and decline, investment and divestment just like a publicly traded company or any other economic entity.  The fact of the cycle is predictable, but its exact path is not. We want to invest in cities with trending population and economic growth, but we also want to diversify across multiple cities because we do not know the path of the economic cycle for any particular geography with certainty.

Product Type

 Multifamily properties are rated based on their age in descending order from newest to oldest (Class A – C). These product types have different performance characteristics when considered as investment vehicles.  Class A properties, for example, have low maintenance costs, are situated in the best parts of town and attract the most affluent renters. For that reason, they are attractive to institutional investors like insurance companies and large family offices, but they are the most sensitive to economic downturns and are the first properties to offer concessions and discounts. Class C properties are the oldest, have high maintenance costs and attract tenets with lower socioeconomic status, but may be able to maintain very high levels of occupancy because tenets cannot afford to easily relocate.  Class B apartments exist between these two extremes.  Diversifying across product type to some extent also makes sense because, when considered as an investment, the different product types will perform differently through changing economic environments.

Ownership Structure

Ownership structure refers to the way in which the investment capital is deployed and how ownership is allocated to investors within the framework of a real estate syndication. In a single asset investment, capital is deployed into a specified, pre-identified property. As an investor you know exactly what you are investing in from the outset.  In a multi-asset fund structure, the sponsor is raising capital investment for a specified concept.  That could mean Class B properties in the Midwest that deliver a certain amount of cash flow. Or it could be Class A properties in high growth metros with a goal to achieve a certain multiple on invested capital.  Whatever the specifics, a fund will spread capital over multiple properties and potentially multiple geographies, but as an investor you do not know exactly what you are buying until the sponsor acquires the assets.  A multi-asset fund provides one kind of diversification but not others.

As an example of what this could look like, the chart above shows how my portfolio of multifamily syndication investments are diversified across the parameters discussed. I made an effort to keep these concepts in mind as I made capital allocations over time.  I think it represents a reasonable example of diversification across the relevant factors. One potential area of over-concentration risk that I see, is my exposure to the state of Texas. Any adverse state-wide economic or political changes could have a negative impact on three of the seven investments I currently hold. Additionally, I have invested more than 50% of my real estate capital with one operator.  I have confidence in that company, but if company factors changed unfavorably there could be a material impact on more than half of my portfolio. Remember, there is no perfect diversification method. This is an ongoing and evolving process that each investor should engage and develop for oneself.