Real estate professionals categorize real estate investment opportunities by their risk-return profile. We have clustered all potential investments into four groups. See the chart below to see where each of these investment types falls in terms of risk and return potential.
As with all investments, investors who assume more risk should be compensated with greater potential upside, or return. This concept is not specific to real estate but applies to all investments whether they be stocks, bonds, commodities, alternative investments, or any other investment.
I will define and share examples of each of the four food groups below, starting with the most conservative and moving to the most risky.
The risk-return profile of core investments is conservative. These assets are low risk because they are in high quality locations, they have strong creditworthy tenants, and they are newer properties that are well built. Because they are less risky than the other types of investments we will cover, they generate lower returns. They generate stable and consistent cashflow and their values tend to be the most stable as well. In general, investing in core assets is the most passive form of direct CRE ownership–another reason why returns are lower. Even though these assets are considered the least risky, they inherently have risk and will require a team to oversee the operations. Sometimes, unexpected challenges arise even at the assets that appear most stable.
Buyers of core properties are generally institutional investors with a very low cost of capital and very conservative business plans. Operationally, they are very efficient because they have high occupancy rates and long-term leases to creditworthy tenants.
Returns are typically between 6-9% on a levered basis. These investors typically use low levels of debt–anywhere between 40-55% typically. These investors typically have very long hold periods as well.
Core Plus assets meet much of the above-mentioned criteria; however, they are missing one or more of the characteristics of a Core asset. For this reason they are slightly higher on the risk-return profile. The property could be new and leased to high-quality tenants but is located in a secondary market or in the suburbs. It could be in a great location in a gateway market, but it is 20 years old (like the photo below) and doesn’t have all the bells and whistles the top tenants are looking for.
Core assets have limited risk and, therefore, generate limited returns. The returns are slightly higher than Core assets (200-300 bps levered), and have slightly more risk. As you can imagine, larger investors and institutions who are seeking better returns than those obtained through Core investments, are the primary buyers of Core Plus deals. These deals are often too large or don’t provide the yield required by syndicators. They generally use conservative levels of debt, although slightly higher than buyers of Core properties.
Core plus owners can typically improve net operating income and cash flows by light improvements, improved operations, or marketing and leasing strategies. Since there is a bit of hair on these deals, investors can oftentimes (not always) create a bit of value by overcoming whatever challenge prevented the asset from being characterized by Core. For example, if the asset is Core Plus because the tenant credit is weak, then replace the tenant(s) with more creditworthy tenant(s) and secure long-term leases. However, if the market is the reason the property is not considered Core, then you are not going to be able to bring it up.
Value Add properties are those with a moderate to high risk-return profile. These properties sit between stable Core Plus assets and Opportunistic deals that typically involve substantial construction risk. Value Add properties are underperforming or underutilized assets that can be improved to drive greater NOI and cash flow. These investments can result in substantial returns if executed efficiently. Typically, Value Add properties are in strong locations but underperform because of dated finishes, deferred maintenance, or have simply been operated poorly.
Value Add investments require hands on operators who have experience turning around assets. Therefore, it is vital that the investor/sponsor have a track record and a team capable of carrying out the project. If the project involves construction, then there is added construction risk not found in Core or Core Plus investments.
The objective of the strategy is to buy at the right price, invest capital in physical improvements or deferred maintenance, or fund tenant improvements or pay leasing commissions to increase the tenant credit and rental revenue. This generally involves getting a loan to cover the costs of these improvements. Ultimately, the goal is to boost NOI and bring the quality of the asset up to Core Plus criteria so that it can sell at a lower cap rate.
Value Add investments typically have a shorter hold period than Core and Core Plus investments. The goal is to increase the value of the property by making physical upgrades, improving operations, and securing better tenants. Once this has been accomplished and the property is stabilized, value add investors want to capitalize on the appreciation and redeploy the capital into a different investment rather than hold, as it will lower the IRR.
Smaller institutional investors get involved in value add investments; however, the majority of value add opportunities are pursued by syndicators and private investment firms.
Opportunistic deals are those that involve the most risk and the greatest potential upside. This asset class is not for the faint of heart. It is also not for inexperienced investors and operators. Land entitlement or assemblages, ground-up development, major renovations of existing property, and adaptive-reuse projects, are examples of opportunistic investments. Because of the complexity involved in successfully executing an opportunistic business plan, the team involved must be experienced and extremely competent.
These investments have very little, if any, cash flow so projects of this type require well capitalized investors or financial engineering to be able to cover the costs during the improvement phase of the business plan.
Long lead times are another reason for which opportunistic deals are the most risky. When you are doing ground up development, for example, you are speculating about what the future will look like in 2-5 years. Much can happen with regard to the economy, market conditions, interest rates, construction and labor costs, etc. that if timed inappropriately, the project could fail.
Because of the outsized risk, opportunistic investments have the highest potential returns of all investment types.