Real Estate Investment Strategy: Four Categories of Risk & Reward
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Understanding the terminology of commercial real estate strategies can make a difference in choosing a property that has the greatest chance of producing the desired outcome. It is true that there usually is a positive relationship between risk and return, but the adage that “the greater the risk, the greater the return” states it imprecisely. Willingness to risk more offers an investor the potential for higher return. Investors have an opportunity to select a strategy that matches risk tolerance to financial goals.
Low Risk – Low Return Strategy: Core
Core assets offer the lowest level of risk among the four commercial real estate strategies, and they also require the least participation by investors. With characteristics that classify them as highly desirable in the most sought-after locations, they are among the most expensive. Their expansive size and high prices often make them the choice of institutional investors and real estate investment trusts that have access to large sums of capital.
Class A properties that have long-term occupancy possess qualities that make them highly desirable to tenants, and they are often fully leased. With locations at the best addresses in the nation’s most fashionable downtowns, core assets are often the choice of investors who prefer a safe return. Without an expectation of appreciation in value, investors in core assets can expect a stable and reliable cash flow as a Real Estate Investment Strategy.
A characteristic of core assets is the passive investment status of investors. With properties such as upscale facilities for government agencies, high-rise apartment towers or office buildings, core assets satisfy investors who prefer capital preservation and long hold periods. The absence of a need for improvement typically results in little upward movement in value.
While not offering the attractiveness of properties that have a higher yield, they offer considerable advantages. In an economic downturn, they are the least likely to experience a loss of tenancy. Not as liquid as stock securities, they provide investors a way to cash out more readily than higher risk properties can provide. The upside of core investments is their steady reliability with minimal risk.
Low Risk-Moderate Return Strategy: Core Plus
Wanting an asset that has the characteristics of the core strategy but without a path to increasing net operating income (NOI) leads some investors to choose core plus. Investors can have the opportunity to obtain a stable cash flow from highly attractive properties in the largest markets such as retail and office buildings, multifamily dwellings and commercial or industrial facilities. While generating and preserving capital, such an investment can produce a higher NOI.
Determining the justification for the increase in value requires estimating the potential rental income (PRI) for a fully leased property. Also, it necessitates subtracting losses from tenants who default on payments or vacate the property. Other sources of revenue such as fees for parking or the use of laundry facilities can increase the PRI. The sum of all sources of income provides a gross estimate of operating income, but operating expenses can reduce the amount considerably.
By deducting the cost of utilities, taxes, insurance and maintenance, an investor can arrive at an estimated NOI. Ascertaining the viability of increasing it through options such as build-to-suit require careful consideration. While core plus assets resemble core in most characteristics, there are some significant differences. Properties may not have a location that is as advantageous as those in the core strategy, or age may create a slightly negative impact on their appearance.
Moderate Risk – Moderate Return Strategy: Value-Add
Investors who choose value-add properties want to increase value by analyzing the potential defects that make correcting it possible to accomplish the goal. Properties often have a discount that appeals to a value-add investor who plans to make significant changes before offering them for sale. Other investors who prefer an income producing property that does not require hands-on management or personal involvement may choose a refurbished property. Developing practices that correct obsolescence or apparent neglect, as well as options that increase tenancy, can give investors an opportunity to make a property more attractive.
A goal of many investors in a value-add Real Estate Investment Strategy is to sufficiently improve assets to a level that allows them to qualify as core investments. Value-add assets typically have a cash flow in place, but investors usually want to increase it by implementing higher rental rates. However, increases typically require making changes that current occupants can see, appreciate and accept.
The potential for appreciation encourages investors who can manage an upgrade in the physical appearance of an asset or changes to policies. A new approach to management functions can increase tenant satisfaction that makes the property more valuable and more attractive to investors who prefer a low-risk investment. By increasing the net operating income, investors may choose to sell in order to capture the appreciated value.
High Risk – High Return Strategy: Opportunistic
Investments in opportunistic assets offer the entrepreneurial risk levels that can produce double-digit returns when the business plan that supports them succeeds. The improvement of opportunistic assets may require specialized knowledge of recapitalizing distressed properties and complicated financial structures. Turning assets around may appeal to sophisticated, high-risk takers. Such investors resemble those who prefer the value-add strategy, but they take it to a higher level of risk in search of higher return. By accepting the highest level of risk and by providing exceptional expertise, investors in opportunistic assets may achieve double-digit returns.
Challenges that face investors in distressed properties such as high vacancy levels, as well as significant structural or financial issues, may face investors who choose to purchase distressed properties. Opportunistic investments may include foreclosed assets from banks or other undermanaged properties. Typically not income producing, distressed assets have little cash flow or even none in some cases in addition to a significant amount of debt financing. Investors usually hold such properties for three years or less and realize returns by selling at the peak value.
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