How to diversify properly with property

Wanting to preserve wealth by ‘not losing money’, grow wealth safely, and create an income you can be confident in throughout market changes are the most pressing priorities for the kinds of investors we work with in property.

If this sounds like your client, it makes sense to consider how they can diversify their property portfolio.

Sector diversification

Firstly, it is worth considering sector diversification. For example, the long-term rise in online retail, which is reducing demand for High Street shops, does not necessarily impact demand for housing nearby.

The easiest way to diversify a property portfolio is to invest in a diversified fund or real estate investment trust

Commercial property values are driven by commercial activity in an area, and its impact on rents. Residential property values are driven differently, for example by living standards, demographics, and economic activity. Ultimately, this sector is relatively stable since supply is constrained, and yet demand is strong and growing, since we all need a roof over our heads. 

Within the residential sector, there is then a wide range of sub-sectors including private rental housing (that is, property rented by a landlord to a tenant), social housing, student accommodation and later living.

Perhaps the easiest way to diversify a property portfolio from a sector perspective is to invest in a diversified fund or real estate investment trust.

REITs own or finance income-producing real estate across a range of property sectors, and are mostly traded on major stock exchanges. For example, British Land has £13.7bn assets under management at the time of writing, diversified across assets including offices and retail buildings. 

However, such investments do not offer the tangibility, low volatility and control that attract so many investors to property in the first place. So what if the client prefers to focus on direct investments – owning ‘bricks and mortar’ that they can control?

In an environment of rising regulations, it is increasingly preferable to focus on just one sector or sub-sector, or to work with someone who specialises in their sector. This is because a lack of specific sector knowledge creates additional risk, which can easily outweigh the benefits of diversification. A saying from Warren Buffett is relevant here: “Wide diversification is only required when investors do not understand what they are doing”; or “keep all your eggs in one basket, but watch that basket closely”.

Let’s say you have decided to focus on residential property investment. Within this, there are significant benefits to diversification, including:

• Geographical diversification
• Number and type of properties
• Number and type of tenancies.

Where should you invest?

Geographical diversification is about avoiding concentrating risk in a particular area. For example, news that a major employer is leaving Croydon, south London might influence demand for property in that area, but it will not affect investments in Manchester.

The vast majority of investors in the UK choose to invest within 10 miles of their home. This has the advantage of ‘feeling safe’. However, it can also mean easily avoidable risks, since a change in the local market such as a new selective licensing scheme could wipe rental profits in one fell swoop.  

To achieve geographical diversification, firstly, the investor needs to be able to acquire quality assets. Then they need to ensure they are managed in a way that is profitable and compliant. Doing this on the side of a job is increasingly difficult in a fast-changing, increasingly regulated environment.

Unless the property portfolio is the client's business, it is increasingly likely that they will need to outsource to reputable specialists on the ground with strong local and national market insight if they want a diverse, risk-minimised portfolio.

Types of property and number of tenancies

Having some diversity in terms of ‘kit’ makes sense, since tastes, preferences and regulations change over time.

For example, for many years gardens were seen as a burden by many tenants. In 2020, repeated lockdowns reversed this trend, and suddenly houses with gardens were selling and renting like hot cakes.

For example, in the fourth quarter of 2020, it took 30 per cent less time to let a house than in Q4 2019, and searches for gardens went through the roof.  

To emphasise the benefits of having a range of types, and a higher number of properties, let’s say the portfolio consists of two flats in Chelsea, west London.

A change in preferences, regulations or local demand could affect the value of the entire portfolio. If you had instead bought one flat in Chelsea, two houses in Cambridge and a low-rise block of 12 flats including freehold in Liverpool, then a change in preferences, regulations or local demand would only damage the portfolio if it was an unavoidable sector-wide change.

This same example illustrates another sensible way to diversify the portfolio. For income-focused investors, having a larger number of tenants is a great way to limit the downside.

In the above example, your two-flat portfolio would have two tenants. Both might be workers who moved to the UK for their job, so a change such as Brexit or Covid could negatively impact the rental income across your portfolio. By contrast, the second portfolio has 15 tenancies in total.

A change in circumstances for one tenant is unlikely to affect the ability or willingness of the other tenants to pay their rent. 

How to diversify

Geographical diversification helps minimise exposure to local changes. Asset diversification helps minimise exposure to changing preferences. Tenant diversification helps minimise exposure to issues affecting a particular tenant or type of tenant.

At this point, you might be wondering how to successfully create and manage a portfolio with diversity in terms of geographies, asset types and tenancies.

While this might have been difficult 10 or 20 years ago, we are now in an age where more is possible in an hour than would have been possible in a week, at the click of a few buttons. 

Firstly, you need the right team on the ground – whether this is outsourced to individual service providers, to an end-to-end provider or, if you are at a larger scale, a team you have hired.

Secondly, you need the right technology and systems to ensure acquisition and management are efficient, responsive and effective, from cloud-based documentation to maintenance handled through an app.

If your client is looking to grow their property portfolio as a way to protect and grow their wealth, and create a passive income in the 2020s, then it must be done in the right ways, with risks minimised.

One of the best, time-tested ways to do that is through geographical, asset and tenant diversification. For this, you need the right teams, tech and systems.

Anna Clare Harper is chief executive at SPI Capital