Investments are typically grouped into four primary categories based on investment strategy and perceived risk. Those four categories are core, core-plus, value-add, and opportunistic. The key differentiator between these categories is the risk and return profile. Moving between these strategies is a bit like stepping up the ladder in terms of taking on more risk, and in theory, being compensated for that risk with a higher return. You can apply these four different strategies to all types of CRE (i.e. core office building, value-add retail, and core-plus multifamily, etc).
Investing in Core Real Estate Assets
Core assets, considered the safest, sit at the bottom of the risk-return ladder. Core properties are relatively stable assets in major metros, such as high-rise office towers or apartment buildings in downtown locations in major cities like New York City, Chicago, or San Francisco. They are usually best-in-class properties in the best locations, with high, stable occupancy and credit tenants.
Core assets can be quite large and expensive and, therefore, are usually owned by well-capitalized entities, such as REITs and other institutional investors. Because they are stabilized and already achieving market rents, there is not much value an investor can add, which obviously limits their upside. As a result, due to a lack of value-added opportunities that also offer a low-risk profile, core investments usually translate to single-digit annual returns. Leverage with core: typical range from 0% to 50% of asset value – rarely higher. Leveraging core assets adds little to leveraged returns, while also increasing risk.
Investing in Value-Add Real Estate Assets
A value-add strategy takes a bigger step up on the risk-reward ladder. Value-add assets generally have a problem that needs fixing, such as interior renovations to keep up with new construction, envelope repairs to cure building deficiencies, or upgrades to amenity spaces to improve competitiveness in a market. The purchaser is usually coming in with a specific business plan to improve an under-utilized, obsolete asset. One example is a shopping center that has lost an anchor tenant, such as a grocery store or other big-box tenant. The purchaser will have an opportunity to buy that property at a discount given the absence of an anchor. If the new owner has an effective business plan to reposition the anchor space (possibly by demising it into two to three spaces) and bring new tenants to the property to improve the overall shopping experience, the new owner can make a substantial profit. Since more risk and effort are required to successfully execute this business plan, these investments often provide leveraged returns in the high teens, between 15% – 19%. Leverage with value-add: 65% – 85% of asset value/cost. Unleveraged returns on value-add assets are high enough to entice additional use of leverage to further enhance leveraged returns.
Investing in Opportunistic Real Estate Assets
Opportunistic assets sit at the top rung of the risk ladder. These deals are generally ground-up construction or extreme turnaround situations. In the case of a turnaround, there are significant problems to overcome, such as major vacancy, structural issues, or financial distress. Sometimes referred to as “distressed assets”, opportunistic strategies may involve acquiring foreclosed properties from banks or servicers or acquiring the senior loan at a discount from banks or servicers with an eye toward eventual foreclosure. Opportunistic investments were plentiful in the wake of the financial crisis, as bold investors stepped in to buy distressed properties from banks at deep discounts from previous sales. In some cases, opportunistic investments require special expertise to execute the turnaround plan, or patience to wait-out a downturn in the market. Because opportunistic investments carry the highest risk and require the greatest expertise, they can provide annualized leveraged returns of over 20%. Leverage with opportunistic: 0% – 85% of asset value/cost.
It is important for investors to understand the risk and return relationship when considering the four different types of real estate investment strategies. The level of the return should be commensurate with the amount of risk. Specific to value-add and opportunistic strategies, investors also need to keep in mind the expertise of the sponsor and their ability to create and execute a business plan, both of which are critical to the success of a project.
A well-balanced commercial real estate portfolio may include some – or even all – of these different investment strategies depending on the risk tolerance of the individual investor.
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