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Balancing Risk and Return: Differences Between Core, Value-Add, and Opportunistic Real Estate Investing Strategies

Understanding Risk and Potential Returns

Investors have many options when deciding to allocate their investment capital. Most decisions, however, come down to a balance between risk and potential returns. Risk in investing is the likelihood of financial losses or adverse outcomes, up to and including total loss. A rule of thumb in the investing world is that the possibility of above-average returns is only available to investors willing to assume above-average risk. If an investor wants to limit risk from their investment strategy, they should not expect outsized returns.

How to Measure Investment Risk

Standard deviation is a metric commonly used to assess the risk of an investment. It refers to the average amount that individual results or outcomes will differ from the mean — either above or below.

Consider a stock with a high standard deviation. This means that the value of that stock could be significantly higher or significantly lower than its mean value at any given time. Investments like this are said to have high volatility, while investments with smaller standard deviations have low volatility. The concept of a risk spectrum is consistent throughout all asset classes.

How to Measure Total Net Returns from Real Estate

Real estate generates returns for investors in multiple ways:

  • Operating income — rents and other revenues collected less expenses produces operating income.
  • Appreciation of value — well-selected and well-maintained properties tend to grow in value over time, which can be harvested in cash by refinancing or selling the asset.
  • Tax advantages — real estate investors can benefit from taxation laws that can may reduce their tax liability, keeping money in their pockets.

Just as portfolios can be diversified, real estate holdings can and should be diversified as well — different geographic regions, different property types (multifamily, hotels, office, etc.), different security types (equity, debt, etc.), and different strategies.

Now that we have examined risk and total returns considerations, we will explore four key strategies of commercial real estate investment:

  • Core
  • Core Plus
  • Value-Add
  • Opportunistic
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Core Real Estate

Core real estate refers to stabilized property in a major Metropolitan Statistical Area (“MSA”). We refer to “stabilized,” we mean fully rented, often with long-term leases, to tenants with good credit.

The property may be “Class A” — that is, newly built and in excellent condition. Even if the property is older, it has little or no deferred maintenance or faulty systems and requires comparatively little effort to maintain the property. Timing the market is less of a factor for core real estate because its value usually does not shift dramatically.

Core assets are considered “low-risk” in the universe of real estate investment. They usually produce stable, predictable cash flow. They may not realize substantial appreciation, but there is minimal downside risk. Investors are relatively insulated from the possibility of total loss. Core investors may de-risk the investment even more by taking a “low-leverage” approach, financing the property with as little as 25% loan-to-value.

While a core real estate investment strategy may not sound exciting, investors value core real estate as a hedge against volatility and inflation. Keeping a few stable, income-producing assets in their portfolio enables them to assume more risk in other corners of their portfolio.

Core Plus Real Estate

Core plus real estate is similar to core real estate, but with a little more risk factored in.

The property may be older and more maintenance intensive. It may be in a suburb or secondary market. The tenants may be lower-credit and less reliable. The property may be financed at 50% LTV or higher. All of these factors contribute to the risk profile of core plus real estate.

Core plus investments entail more risk, but in the spectrum of real estate investment, the risk is still relatively low to moderate. As such, a core plus strategy can be expected to produce a higher standard deviation.

Market cycles play a bigger role in core-plus real estate strategies than in core strategies. Core plus properties will take on losses in a down market before core real estate will. Accordingly, savvy investors ramp down their core-plus investing sooner than their core investing when the market starts to cool.

Value-Add Real Estate

Value-add real estate is operating below its potential, representing an opportunity to increase the property’s value.

Correctly identifying and executing value-add opportunities can produce significant returns, but the risk profile is proportionally higher than the risk profile of core or core-plus opportunities.

Value-add opportunities may need significant repairs. They may be leased passively to maintain occupancy, or they may be filled with low-credit tenants. The tenants may be paying below-market rents. With targeted upgrades and improved management, the property may attract a better-quality tenant and command higher rental rates. Tenants may be willing to pay extra fees for added perks and amenities.

There may be opportunities to reduce expenses as well — reducing utility and administrative costs, seeking property tax incentives or reassessments, or investing in technology to improve efficiency.

Increasing income and reducing costs increase the property’s net operating income, which has the dual effect of increasing cash flow and the property’s value.

Adding value to commercial property often requires significant cash upfront. Investors often leverage value-add real estate as much as 80% loan-to-value. This increases the risk profile of the investment significantly. If the improvement plan fails to produce results, the property could fall well short of expectations.

Even if the sponsor executes the business plan flawlessly, timing a value-add acquisition wrong could hinder the returns if the value added to the property is canceled by declining real estate prices overall. A sponsor, often known as the general partner or GP, is the organization or group of individuals responsible for raising capital, acquiring real estate projects, maximizing value, and returning any profits to investors. Investors might be more careful about value-add acquisitions if a market shows signs of overheating or leveling off.

But if the business plan succeeds, value-add real estate can produce returns significantly better than core or core-plus investments.

commercial_real_estate_strategies

Opportunistic Real Estate

At the top of the real estate risk ladder, we find opportunistic real estate. This strategy is similar to the value-add strategy, but the target property may be in even worse shape.

It may be completely vacant. Core systems like plumbing or electricity may need to be overhauled or replaced to make the property habitable. It may be a tear-down or a new development property.

Opportunistic property can be acquired for prices well below their core asset counterparts, but significantly more money and leverage are usually needed to complete the project. Since these are projects with greater variability, a lot can go wrong. Opportunistic investing carries with it the highest risk of total loss.

Timing plays the greatest role in an opportunistic strategy. It can take months or even years to execute the kind of rehab or repositioning needed for an opportunistic investment. The investor needs to consider today’s market conditions and market conditions months or years from now.

But with great risk comes the potential for great reward. If the sponsor can execute the business plan, opportunistic real estate can reap the highest potential return when compared to core, core-plus, or value-add real estate.

Conclusion

There’s no one way to “invest in real estate.” The four strategies outlined above are similar to each other in some ways but differ in others. Investing in commercial real estate comes down to evaluating the risk profile and potential returns of investment opportunities to ensure it matches up with an individual investors’ investment objectives.

risk_and_return_spectrum

Not every strategy will be appropriate for every investor. Conservative investors or ones with shorter investment time horizons may value protecting their principal and building a stable income. However, this strategy may limit investors to core real estate, or maybe some core-plus investments.

Speculative investors — investors with a long runway or an appetite for higher potential returns — may focus on value-add and opportunistic strategies.

The bottom line — private market real estate can offer an investor the ability to diversify assets by adding alternative investments. Regardless of the individual’s risk tolerance and goals, commercial real estate is worth considering when building a well-balanced portfolio.


Sources:
1. The Return Spectrum

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The NPI is a quarterly, composite total return for private commercial real estate properties located in the United States. The NPI includes operating office, retail, industrial, apartment, or hotel properties accounted for on a market value basis and includes the impact of leverage employed on the properties in the index. The NPI Levered Index is illustrative of historical average annualized commercial real estate returns on a gross property level leveraged basis, and these historical returns may not be indicative of future results. Leverage adds additional risks because leverage providers generally get paid first and may have a full or partial recourse claim against a portfolio. Such real estate return data should not be used to estimate returns of Jamestown Invest investments. While Jamestown Invest 1, LLC may acquire properties that meet some of the NPI criteria, it may acquire properties that do not meet such criteria. Further, Jamestown Invest property returns may have a better or worse average annualized return performance compared to the index as each real estate investment is unique in nature, which is inherently problematic for benchmarking to the composite returns of a highly diversified index.