From Core to Opportunistic: Real Estate Investing & Risk/Return Profiles
Investors often use different terms to refer to real estate investment strategies. Here's what those terms mean.
We’ve talked before about why you should be investing in real estate as an asset class, as well as about the pros and cons of different types of real estate investments. Even among similar types of real estate investments, though, private equity and institutional investors often use different terms to categorize investments. What is a “value-add” investment, and how does it compare to an “opportunistic” investment? We discuss in this article.
It helps to think of the different types of real estate investment strategies as a stepladder. At the bottom of the stepladder are “core” investments. These investments are less risky, but can be expected to generate smaller returns. As you go up the ladder, your projected returns increase - but so does your potential risk.
Core investments are generally stabilized, low-leverage “trophy” office properties located in the central business district of major metropolitan areas (think New York City, Chicago, Washington DC). These properties feature credit quality tenants on long-term, triple net leases. In many cases, the tenants are national franchises that are supported by rent guarantees from the parent company, adding additional security for the investor. Returns can be anywhere from 6-11%. Institutional investors often acquire core investment properties in order to generate a reliable, conservative return.
Core-plus investments are similar in most ways to core investments, but are lacking one or two of the features of a core investment. For example, a Class A office building in the central business district of a primary market might be considered a core-plus investment if it has several tenants with expiring leases. In this case, the core plus investment would generate less of its return from current cash flow, but have the potential for increased returns via rent increases. Core-plus investments are good options for investors who want a safe return, but with a little bit of upside. Returns can vary, but are generally around 9-12%.
These types of investments can be found in primary, secondary or tertiary markets. This strategy is exactly what it sounds like - the sponsor is seeking to “add value” by making some kind of change to the property. As one example, a sponsor may purchase a distressed property at a discount, and then make repairs. Another example includes acquiring a property with a high vacancy rate. and renting the vacant units out through more effective marketing. These properties usually require additional leverage to acquire, which accounts for much of the increased risk. Returns, though, are higher than core and core-plus investments. Value-added investment returns are between roughly 12-18%. These can be very successful investments, provided that the investor has confidence in the sponsor’s ability to make the necessary improvements.
At the top of the “stepladder” are opportunistic investments. There are many types of opportunistic investments, but generally these are either highly distressed properties, new development projects, or properties in emerging markets. In many cases, opportunistic investments are generating little to no current cash flow and are highly leveraged, making them risky for obvious reasons. Much of the return on these investments will be generated on the back-end, in the form of future rental income or the sale or refinancing of the asset. Despite the risk involved, the high overall returns (generally 18%+) of opportunistic investments are attractive to sophisticated, wealthier investors. Again, though, anyone considering this type of investment should be sure to research the sponsor’s track record extremely carefully.
These aren’t intended to be complete definitions - some real estate investments will have elements of different categories. However, this is how real estate private equity firms categorize investments, and many real estate crowdfunding platforms use these terms as well.
So which types of deals should you invest in? Investor Ian Ippolito notes that studies have found that the safest portfolios consisted of (not surprisingly) mostly core and core-plus investments. Investors seeking greater returns can increase allocations in value-added and opportunistic investments, but not without exposing themselves to greater risk. These studies, though, assume no specialized knowledge on the part of the investor. Investors with specific knowledge of local real estate markets and knowledge about the sponsor can sometimes do better for themselves by relying upon that knowledge. Investors should also consider each investment in the context of their own personal investment goals and investment time horizon.
Of course, much of this discussion would have been moot up until several years ago, as most ordinary investors did not have the ability to invest in large commercial real estate properties by themselves. Real estate crowdfunding has opened new investment opportunities up, and investors can find all of these different categories of deals on crowdfunding platforms. Whatever your investment strategy is, crowdfunding for real estate allows you to make the investment that’s right for your portfolio.