Understanding Core, Value-Add, and Opportunistic Commercial Real Estate Investments
At RealtyMogul.com, we offer our investors the opportunity to participate in a wide range of different types of commercial real estate investments. While navigating the different offerings, potential investors will often notice that each project has a unique story and an expected return that is commensurate with its level of risk. Understanding the differences between deal characteristics will help the investor select a project that aligns with their investment timeline, appetite for risk and expected return.
Many investors seek opportunities in commercial real estate as an alternative investment to stocks and bonds, offering diversification as well as a different risk and return profile. When comparing different types of commercial real estate investment opportunities, most investors are familiar with the different types of deal characteristics—property type, tenant profile and location often being at the top of the list.
Investors can choose from an array of different commercial real estate property types, such as multifamily apartment communities, retail shopping centers, suburban or central business district (downtown) office buildings, flex industrial parks, hotels, and even more niche property types such as student and senior housing facilities, self-storage, and mobile home parks. Each property type has a unique set of characteristics that dictate how the property is managed, its level of risk given market conditions, its relative liquidity and expected level of return. For example, all other factors being equal, workforce apartment communities would generally be considered to be less volatile and subject to changing market conditions than hospitality properties, which are by nature more seasonal and luxury offerings that correlate more closely with economic conditions in the market.
Another deal characteristic that is often an area of consideration for real estate investors is the type of market in which the asset is located. Primary markets generally bare lower risk than secondary and tertiary markets which are often more susceptible to market cycles and fluctuations in demand. Imagine the difference in demand for an apartment or office property in downtown Manhattan or San Francisco when compared to smaller, less densely populated markets in more remote areas. The core, highly desirable markets will often see a smaller fluctuation in rents and vacancy rates in a declining economy due to the high level of demand drivers and dense population in the area.
When analyzing commercial real estate opportunities, investors should also consider the proposed business plan that the operator plans to undertake, which can be as simple as purchasing and holding an asset or as complicated as developing a new building from the ground up. The business plan should be set forth prior to the purchase of an asset and defines the plan of attack from acquisition through disposition, including changes to the property, possible expenses incurred, projected rent increases, and an estimated timeline or hold period. The business plan of a project will have strong implications on its level of risk to investors.
Commercial real estate investments can be divided into different segments that broadly categorize them based on various characteristics of the deal. These segments are often defined as Core (and Core Plus), Value Add, and Opportunistic investment strategies. Each of these investment philosophies lie at a different point on the risk vs. return spectrum, with core investments considered to be the least risky with the lowest expected return and opportunistic investments offering the highest level of risk along with the highest expected return to investors.
Core investments are considered to be the least risky because they often target stabilized, fully leased, secure investments in major core markets. These include properties with long term leases in place to high credit tenants and Class A buildings in highly desirable locations. These buildings are often well kept and require little to no improvements on behalf of the new owner. Therefore, these type of real estate investments generally do not experience significant appreciation in value but rather provide stable, predictable cash flow with relatively low risk. This type of investment suits investors who seek capital preservation and long hold periods, and often warrants low leverage acquisitions. While these types of investments may seem less attractive when compared to higher yielding commercial real estate opportunities, many investors view them as attractive investments for the level of risk they provide when compared to other investment opportunities in the marketplace such as corporate bonds and publicly traded equities. While core investments in commercial real estate are typically not as liquid as securities offered on an exchange, they are generally the most liquid assets when compared to value add and opportunistic projects because they are stabilized, attractive, marketable assets.
Value-add commercial real estate investments typically target properties that have in-place cash flow, but seek to increase that cash flow over time by making improvements to or repositioning the property. This could include making physical improvements to the asset that will allow it to command higher rents, increasing efforts to lease vacant space at the property to quality tenants, or improving the management of the property and thereby increasing customer satisfaction or lowering operating expenses where possible. Once the operator has successfully increased the net operating income at the property, they typically seek to sell the asset to capture the resulting appreciation in value. These operators often employ the use of medium to high leverage to finance their projects and increase returns to themselves and their investors. Successful value add projects will typically generate higher financial returns to investors than core investments due to the appreciation in value, however these project bear more risk due to the fact that at the time of acquisition, the property is not operating at its full potential—often times because it is not fully leased, is leased at below market rents, has not been properly maintained or is poorly managed. If the operator does not execute their proposed business plan, they can fail to meet their projections and could be forced to sell the property at a lower price than expected. For many investors, however, value add projects provide the perfect balance of risk vs. return—offering in-place cash flow at the time of acquisition with significant upside potential in the form of value appreciation.
Opportunistic real estate investments follow the value add approach but take it a step further on the risk spectrum. Opportunistic properties tend to need significant rehabilitation in order to realize their potential. Often times these assets will be fully vacant at the time of acquisition or the operator will seek to develop raw land from the ground up. These types of projects offer the highest level of return if the business plan is successful, but also bear the most risk as the properties have little to no in-place cash flow at the time of acquisition and have the most complicated business plans. Sponsors for these projects typically employ the use of high leverage and are often subject to less favorable debt terms and higher interest rates than more stabilized properties. If opportunistic business plans are successful, they generally achieve higher returns to investors than core or value add strategies through substantial appreciation in value.
Investors in commercial real estate should consider these different types of strategies and choose investments that match their preferences for investment timeline, relative level of risk and expected return. At RealtyMogul.com, we offer a range of products to fill the needs of our diverse group of investors. Learn more about our different types of investment opportunities on our FAQ page or by contacting our investor relations team.