Building a Commercial Real Estate Portfolio: Should You Diversify?

There are many options for those wanting to invest in commercial real estate. Choosing among those options depends on your objectives, time frame to achieve the desired return and risk tolerance. Investors building long-term wealth will want to pursue a diversified real estate portfolio.

Before making any investment decisions, know your investment goals. Be as specific as possible. Consider the amount of money you want to generate from your investment, the time you will allot to reach that amount and your risk tolerance. Risk is an inherent aspect of investing and typically equates with a loss of money. The bigger the potential gain, the bigger the risk. Think hard about how much you’re willing to lose before you begin to invest, or plan to spend many sleepless nights worrying about your investment.

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Why Diversify Your Real Estate Investments

The word “diversification” is so much a part of any conversation related to investment portfolios that it’s easy to forget the reason for diversification. Investors diversify because spreading capital amongst various investment vehicles reduces your risk. For example, a diverse financial portfolio will have a mix of stocks, bonds, cash and possibly other asset classes, including real estate. No single asset class performs well 100% of the time, so if stocks are down, bonds may be up, thereby balancing your risk.

The same is true with a diversified commercial real estate portfolio. If one property (or an entire sector) fails to perform (think office buildings during the height of the pandemic), only part of your portfolio takes the hit. The adage, “Don’t put all your eggs in one basket,” is especially apt for investing. Concentrating capital around a single investment can lead to catastrophic losses if that investment fails.

Specialization versus Diversification

Diversification is a widely accepted best practice for reducing risk, so it’s natural to wonder why people fail to diversify their real estate portfolios. The answer is that specialization—focusing on a single or limited class of commercial property assets—can offer outsized returns. One well-performing investment is like winning the lottery and can build a fortune. The flip side is that concentrating all your money on a single specialization is risky. A poor investment decision can cost you your entire investment.

While diversification typically means less risk, overly diversified and undisciplined portfolios can be challenging to manage—especially if you’re managing your own portfolio. The complexities of tracking too many projects or asset classes can make it easy to take your eye off the ball and lead to losses in your portfolio. Your goal should be to find a happy medium. Disciplined investing in multiple types of properties offers the best financial results for the vast majority of investors.

Changing Market Conditions

Another factor to consider is the unpredictability of the real estate market. Real estate is not a liquid asset class (it requires a willing buyer), so you can’t rebalance your portfolio quickly if market conditions become unsustainable. Also, most investors leverage real property investments with borrowed money, so you face additional risk associated with rising interest rates.

Types of Commercial Real Estate Investments

There are five basic real estate investment types in the Chicago area, with many variations. Following is a brief look at the pros and cons of each.

  • Land – Investing in land can be rewarding if you understand the market and have a strategy to generate profit. Land that is not earning income will be a drain in taxes and upkeep. Many investors lease rural land for agricultural use and hold it for future development. Most urban land is purchased for building or other specific purposes.
  • Office and Retail Space – While office and retail space are similar, they have unique business needs that impact demand and investment decisions. The pandemic changed some market norms. Location remains a critical investment consideration. Both office and retail space call for a site that will support a sufficient number of tenants with the possibility to negotiate long-term leases with built-in rent increases over time.
  • Multi-Family Housing – A well-maintained apartment building in the right location can generate a steady stream of income and quickly turn a profit. Many commercial real estate investors begin with multi-family housing, but it can be a full-time job unless you hire an accredited property manager.
  • Industrial Properties – The most common examples of industrial properties include warehouses, manufacturing and distribution facilities, showrooms and research facilities. Before investing, carefully gauge the potential use and demand of the property. While the shell of these facilities may seem similar, most have specific requirements based on the intended use and are built to spec. Retrofitting can be costly.
  • Storage Units – Storage units are a hot asset in the commercial real estate sector, given their propensity to weather all economic conditions and relatively low maintenance and management costs. Location is critical as the most productive properties are near residential developments (zoned for commercial use), offer easy access and are a sufficient distance from competitors.

Balancing Risk and Reward

If your long-term goals include wealth building, you probably will want to diversify into several projects or asset classes. For those new to investing, we recommend patience. Start slowly with one project and build your portfolio over time. Commercial real estate offers many advantages as an investment vehicle but has some unique risks that you should consider. Following is a quick-hit list of rewards and risks associated with the Chicago commercial real estate investment market.

Rewards of Chicago Commercial Real Estate Investment

  • Wide variety of opportunities in all sectors and locations
  • Gains from multiple sources
  • Risk mitigation through diversification
  • Ability to leverage
  • Long-term appreciation
  • Income generating
  • Tax benefits: deductions, depreciation and deferability
  • Supports wealth building

Risks of Investments in Chicago Commercial Real Estate

All investments carry risk—real estate included. Problems can occur with tenants, zoning, property management, maintenance, changes in the market and more. Key risk considerations include:

  • Requires capital investment that is tied up long term
  • Unexpected economic factors, e.g., a recession or a downturn in a neighborhood, can reduce profits and may require additional investment
  • Complexity requires knowledge and experience that new investors may lack

Inexperience may be an investor’s most significant risk. Promised big returns make it tempting to dip your toe in the investment waters, but always consult an expert (or two) to help you analyze the opportunity and risks. In addition to consulting a financial expert to help you assess your risk tolerance, talk with people who know the local market and understand the asset class and what is required to make the property financially productive. These should not be the same people seeking investor funds, as they have a potential conflict of interest.

How GNP Realty Can Help You With your Real Estate Investment and Diversification Goals

When you’re ready to invest money into commercial real estate and want to know what’s available in the market, GNP can assist with identifying available properties of all types and sectors (residential, commercial and industrial). We can also help you if you already have a real estate portfolio and want counsel on diversification strategies and options.

Our family of real estate businesses offers building owners and investors a single source for tailored, property-related services—from development and construction through management and operations—helping you maximize the value of your investment. Contact us for more information on how we can support your investment strategy.