In the world of investment, diversification is key to achieving optimal returns while minimizing potential losses. Modern portfolio theory (MPT) has long been regarded as the best approach to achieving this balance. MPT is a mathematical concept that aims to select a collection of investment assets that collectively carry lower risk than any individual asset.
MPT operates on the assumption that investors are risk averse, meaning they prefer less risky portfolios that offer the same expected return. Investors will only take on increased risk if they are compensated with higher expected returns. However, the exact trade-off between risk and return may vary based on individual risk aversion characteristics.
One way to reduce portfolio risk is through diversification, which involves holding a combination of assets that are not perfectly positively correlated. By diversifying, investors can lower their exposure to individual asset risk while maintaining the same expected return.
While MPT principles can be applied to diversification strategies in DST (Diversified Security Trust) investments, it’s important to note that DSTs are not always efficiently priced, which can affect the accuracy of modeling. However, there are correlations between risk and return in most DSTs. For example, DSTs with higher leverage and foreclosure risk tend to offer higher returns, while all-cash deals have lower returns but no foreclosure risk. DST properties with lower credit-rated tenants and higher vacancy risk generally have higher returns, while properties with higher credit-rated tenants and lower vacancy risk have lower returns. Additionally, DST properties in tertiary markets with higher re-tenanting risk have higher returns due to higher capitalization rates, while properties in infill locations with lower re-tenanting risk have lower returns due to lower capitalization rates.
DST Diversification Strategies
DSTs provide an excellent opportunity for investors to achieve diversification within a real estate portfolio. With a minimum investment requirement of $100,000 for like-kind exchange investors and $25,000 for non-exchange investors, DSTs offer the chance to invest in multiple assets with different asset classes, sponsors, and geographic locations. Investors have utilized various diversification strategies to reduce risk.
One strategy is asset class diversification, which involves investing in different types of assets such as multifamily, retail, office, and industrial properties. By diversifying across asset classes, investors can reduce the risk associated with industry exposure. With an exchange equity of $200,000 or more, investors can diversify into two or more asset classes with as little as $100,000 in each class. DSTs also offer the opportunity to invest in other asset classes like hospitality, medical office, student housing, self-storage, senior care, and oil and gas. A popular strategy in uncertain times is to diversify half of the exchange portfolio into single-asset retail with credit tenants and long-term leases, and the other half into multifamily apartment complexes. This strategy provides stable cash flow from long-term lease contracts with major corporations while also allowing for cash flow escalation from annual rent increases in residential units.
Asset Class Diversification
Another trend in the industry is combining multiple assets into a single DST. For example, multiple non-contiguous class A multifamily complexes or retail assets with various credit tenants can be packaged into a single DST. With as little as $100,000 equity investment, investors can diversify across multiple geographic locations and credit tenants. With a $200,000 investment, diversification can extend to over 40 locations and tenants. This allows investors to diversify from a single struggling tenant to a diverse portfolio of renters, including some of the best companies in America.
Sponsor diversification is another important strategy. There are many DST sponsors in the industry, each with different sizes, specializations, and levels of experience. Diversifying investments across multiple sponsors helps protect against litigation or other threats to the financial stability of a sponsor. Sponsor diversification often goes hand-in-hand with geographic and asset class diversification, as different sponsors offer DSTs in various asset classes and locations.
Geographic diversification is crucial for reducing risk exposure to local economies, markets, and natural disasters. Economic and real estate markets can vary significantly from state to state and region to region. By diversifying across different geographic locations, investors can mitigate the impact of local economic downturns or natural disasters. Some investors also prefer to diversify into non-income tax states to further reduce risk.