How to diversify your property portfolio.
Too many investors mistakenly believe that just because they have one property in one state, they automatically need to diversify into another.
Instead, what they need to do is to look at it in terms of what are they really diversifying and calculate whether it's really necessary at all.
D is for diversification
Let's consider diversification into a different area, which is the most common one that investors think they need to do.
I would agree with this concept if you're investing in a one-trick-pony town, because you've got all of your eggs in one flimsy basket.
However, if you're looking at most metropolitan areas, you are just a drop in the ocean in terms of the number of properties available.
The caveat to that is if you're over-exposed in one single complex, say you own four townhouses in one building, which may be a situation that beggars diversification.
If that complex gets a poor reputation because of bad tenants or it needs expensive repairs, you'll be too exposed.
Conversely, if you own three properties in different suburbs of Sydney, Melbourne or Brisbane, there really isn't any need to diversify into another State or Territory if you ask me.
Let's explore why investors believe they need to diversify.
One is the risk of that specific area under-performing, which is more likely in a mining or a regional town than a metropolitan growth city or State.
The second reason would be for land tax purposes, however, that usually requires diversification into different entities that hold the properties rather than buying in different States or Territories.
The third motivation for diversification revolves around the types of properties in your portfolio.
If an investor owns all houses, for example, and they're all negative cash flow, they may consider diversifying into units which provide better yields.
Another diversification may be buying in different States because of where the market cycle is in that location.
Understanding diversification
The thing is, there is no sense diversifying into another State just for the sake of it or if the market where you already hold your properties is continuing to perform well.
There is a time and place for diversification, with the main motivation being that you can see a huge upswing occurring – such as in Sydney three or four years ago.
Investors get too hung up on diversifying into different areas rapidly.
Instead they should consider the risks, such as their portfolio being cash flow-rich but equity-poor or if it is heavily tilted towards a large land content, which can have land tax implications, so they might consider diversifying into a different State or ownership entity.
Another diversification that most investors don't consider but should, is lenders.
If you have all your own loans with one lender, then they have the power over your portfolio, which could prevent you from growing it, so you should consider having loans with different lenders.
Is there an ideal time to diversify?
When it comes to diversification, there is no such thing as an ideal timeframe or number of properties.
That's because it depends on each individual investor's cash flow and their exposure levels.
If your portfolio is located in the main metropolitan cities of Sydney, Melbourne or Brisbane, then you are but a small part of a big market and physically can't be over-exposed.
If you are over-exposed in a regional market, then the opposite is true because you're a big part of a small market.
Investors shouldn't worry about having one or two properties in one suburb of a major capital city – that's not a reason to diversify.
What investors really need to consider is liquidity, which means if they can offload a property if they need to sell.
If an investor owns a number of units in one complex, and something goes wrong, would they be able to sell them? Probably not, which is a diversification and liquidity problem.
However, the reverse can be true, because if they own a large portion of that complex, they can control the direction that the building goes – as long as it has upside potential in the years ahead.
The bottom line is to thoroughly consider the many types of diversification.
That's because there is lender, land tax and property type diversification.
Apart from being over-exposed in a regional area, I don't believe diversifying into different metropolitan cities is always necessary.
However, owning properties in each of the major cities of Sydney, Melbourne and Brisbane to take advantage of market cycles continues to be a wise strategy.
The key is to understand whether diversification is a smart strategy for your individual circumstances – or just one that you mistakenly think you're supposed to do.
Read more from Victor Kumar:
The difference between cheap and affordable property