We all know that real estate investing is risky. Still, high potential risk-adjusted returns for CRE investments make the risk worthwhile.
It’s nice to sleep soundly knowing that you took precautions to safeguard your nest egg. That’s where hedging comes in.
Define the Risks
Real estate investments come with various risks at both the investment and operational levels. Your first step to hedge real estate portfolio risk is to identify it.
Let’s focus on investment-level risks for this discussion. Operational risk comes with various other considerations related to asset classes, staffing, tenants, etc. As you can imagine, we can have an entire discussion for each asset class.
Consider the following:
- Macroeconomic – business cycles may reduce demand and inflation reduces the purchasing power of your investment returns
- Credit – debt markets change frequently, and your ability to access affordable credit is not guaranteed
- Local Market – supply of competitive spaces and demand for those spaces impacts your ability to maximize investment returns
- Liquidity – real estate takes a long time to sell, and there’s no secondary market for private placements
Of course, you can identify many other risk factors in your portfolio. However, these are pervasive and drive most of the investment-level risk.
Use the Right Hedge
Hedging is all about protecting your downside risk. Investments with opposite risk forces are a good place to start.
Let’s take a look at some examples.
Many investors often use real estate as a hedge against inflation in a broader portfolio strategy. However, some real estate protects better against inflation than others. For example, properties with higher velocity leasing timelines, like retail and hotels, can adjust to prevailing rents faster than office and industrial investments.
Retail and hotel investments have higher operational and market risks than office and industrial assets, though. In this case, a diversified portfolio with samplings from each will provide both income and value protection.
You don’t have to commit to direct real estate investments to hedge real estate portfolio risk. Publicly traded securities are a common and useful tool in this exercise. This is especially the case when you’re between investments and don’t have enough free cash to enter a private placement or to buy direct.
Consider different types of publicly-traded REITs to balance real estate risk if you want to keep with the theme, though.
Rebalance Periodically
Portfolio construction is never a “set it and forget it” proposition, as many advisors may lead you to believe. However, it doesn’t have to be overwhelming.
Periodic assessment and rebalancing allow you to stick to your strategy without thinking about your investments every day.
Follow these simple steps to keep it simple:
- Establish your desired risk tolerance
- Define allocation to each risk bucket
- Identify liquid hedges – use these between illiquid opportunities
- Set a reminder to review at least quarterly
A good investment advisor will do a lot of this for you, but it’s important to watch them carefully.
**Note: Everyone has a different set of goals and circumstances. This is not meant to be specific investment advice. Speak to your legal, accounting, and financial advisors regarding your situation.