When it comes to investing, there are two major components: risk and return. It’s important to understand their correlation because to become a successful investor, you have to maintain a very delicate balance between the two.
As you probably know-
…the lower the risk, the lower the return.
…the higher the risk, the higher the return.
Understanding different strategies for any type of investing in commercial real estate is no exception.
4 Main Real Estate Investment Strategies
Commercial real estate investments are usually categorized into four main investment strategies:
- Core Plus
It’s important to become familiar with each of these because the strategy you take can help you diversify your investments according to both risk and return.
This is especially important at certain points in the market cycle because these strategies can help you stick to the level of risk you’re comfortable with. Don’t worry, we’ll get more in-depth on each of these in just a moment.
But first, what exactly are the criteria used to define these categories?
To see where each investment might fall, we look at a few key factors:
- Amount of leverage and debt used (how much do they borrow for the deal?)
- Physical condition of the property – great condition, will need repair soon, poor, or needs significant rehab now
- Property location (the market) and tenant demand
- Type of property (multifamily, industrial, office space, etc.)
- Length and terms of current leases in place (long-term leases vs. short term)
With that in mind, let’s look at what each of these categories mean.
Goals: The main goal for Core investors is to generate steady, reliable income with little risk involved. Capital preservation is the key for this type of investor. Cash flow is way more important than appreciation, and the investor is looking to avoid volatility at all costs.
Expected Returns: A Core investor can expect to receive a 7-10% rate of return.
Details about the property: “Core” properties are typically located in prime markets; are fully tenanted, and operating at full capacity. Very little active management is necessary because the property is already considered to be “fully stabilized.”
Use of Leverage/Debt: Low, <40%.
Overall Risk: Low.
An example of a Core investment might be a fully tenanted medical office building with long-term tenants, located in a high demand area.
2. Core Plus
Goals: Core Plus investors are also looking to generate steady income, but are willing to take on a little risk for potentially slightly higher gains. The property might require some slight renovations, but they’re still very high quality and have great tenants.
Expected Returns: 9-12%.
Details about the property: “Core Plus” properties are in very good shape, in a good market, and may require some slight renovations down the line. It is filled with great tenants, but some leases may be up for renewal. Core Plus investors would be wary of this, but would also see it as an opportunity to raise some rents and increase income.
Use of Leverage/Debt: 40-60%.
Overall Risk: Low to Moderate.
An example of a Core Plus might be an older medical building in need of some updates, or larger leases set to expire soon.
Goals: The goals of the Value-Add investor is to have some cash flow initially, but they’re really looking for the potential for increased gains through a solid business plan and smart management.
The business plan will likely include making some renovations, which will increase rents and the net operating income of the property. This increase in Net Operating Income (NOI) “forces” appreciation, resulting in an increased value of the property.
A value-add investor looks at the upside potential. Some consider this the best balance between risk and return because there is some cash flow, but with a larger upside for increased gains.
Expected Returns: 12-18%.
Details about the property: The “Value-Add” property is not operating at full capacity, may have a decent amount of vacancies, and needs updating. It will take some work to get there, and this is dependent on whether the business plan is executed well. There will also need to be some good market timing.
Use of Leverage/Debt: Medium to High.
Overall Risk: Moderate to High.
An example of a Value-Add investment might be an apartment building that hasn’t been renovated in a while, with rents below market. It hasn’t been managed well and currently has a 20% vacancy rate.
Goals: The goal of the opportunistic investor is to primarily look for upside potential and significant returns. Immediate cash flow is not a primary concern. The opportunistic investor is able to see a big vision and see the property as a pathway to significant gains. The investor is content to wait for these returns, which could be anywhere from 3-7 years.
Expected Returns: 15%+.
Details on property: Development deals fall under the “Opportunistic” category. So does positioning a building from one use to another, or even a completely empty building. These properties are often in emerging markets.
Use of Leverage/Debt:
Overall Risk: High, very dependent on execution and market.
An example of an Opportunistic Investment might be a ground-up development.
How do you know what type of investment strategy is involved?
Hopefully, some of the criteria above will help you to figure it out. If not, though, another way is to simply ask the operator. They should have the strategy well thought out and will let you know which way they’re leaning. Their deal offering and expected returns will likely give you the best idea.
Some crowdfunding companies like Crowdstreet even include these categories as part of their labeling, making it even more convenient.
How should you create your portfolio using these strategies?
Ultimately, successfully utilizing these strategies comes from knowing your risk tolerance and what your goals are.
Is capital preservation the goal? Do you just need safe returns, or are you looking to maximize returns? Or, perhaps you’re looking for a balance.
The goal is to match a category to your timeline, risk tolerance, and expected returns.
In this case, I believe diversification is vitally important. I diversify not only by investment strategy, but by location, property type, and operator/sponsor.
A well-balanced portfolio will likely contain investments from each category in different proportions. There’s no such thing as the perfect portfolio because opportunities come at different times–and it’s impossible to time the market.
Suffice to say that there is a portfolio out there that will make you feel comfortable as an investor. It’ll just take doing it for you to figure it out. Fortunately, once you assess your goals, these categories can be extremely useful.
You finished the blog! Great. Now let us know what your questions are. After all, that’s what the Passive Income Docs FB community is for. Hop on over and join us.