Opportunistic, Value-Add, Core Plus and Core are real estate investment types used to define typical returns and risk profiles of real estate investments. These run the gamut from aggressive to conservative. Both the physical aspects of the properties and the “capital stack” dictate the type of investment.
Physical attributes of assets should be the location of the property, the age, and design of the building, length and term of the leases, and the creditworthiness of the tenants. The capital stack (which is the organization of all the capital placed into the investment) is an equally important consideration because it impacts the risk profile of the investment. For instance, a property with a credit tenant and long-term lease in place may be attractive to the conservative investor, but not when 90% of the purchase price is financed with debt.
Below is what you need to know about each investment type.
‘Core’ is equivalent to a fixed income type investment. Think bonds or income stocks. Core property investors desire a stable income with very low risk. Core properties require very little day to day management by owners. This type of investing is as close as one can get to passive investing when buying properties directly. A core property requires very little asset management and is typically occupied with credit tenants on long-term leases.
Core Property investments typically achieve between a 6% and 10% annualized return and use less than 50% debt to capitalize a deal. The majority of the expected return is likely to be generated through cash flow from the property rather than appreciation. Core Properties tend to perform better throughout all real estate cycles, albeit, their returns don’t increase as quickly in the expansion phase.
‘Core Plus’ blends the worlds of core and value-add together. Income generation is a dominant factor in the investment, however, growth opportunities do exist. Core plus investors typically have the ability to increase cash flows through light property improvements, management efficiencies or by increasing the quality of the tenants. Similar to core properties, these properties tend to be of high-quality and are well-occupied.
Core plus investors tend to use between 40% and 60% leverage and expect to achieve returns between 9% and 13% annually.
‘Value Add’ is synonymous with ‘growth’ in the stock market and is associated with moderate to high risk. Value-add properties often have little to no cash flow at acquisition but have the potential to produce a tremendous amount of cash flow once the value has been added. These building often times have occupancy issues, management problems, deferred maintenance or a combination of all three. These investments require a deep knowledge of real estate, strategic planning, and daily oversight by their owners.
Value-add investors tend to use between 60% and 80% leverage to generate annual returns between 14% and 20%.
Opportunistic presents the most risk of all real estate investments along with the highest opportunity for returns. Opportunistic investors take on the most complicated projects that often require a long-time horizon to realize gains. Opportunistic investments require an experienced team and/or sponsor that has significant experience in navigating complex investment strategies. For example, distressed property acquisition, fully vacant buildings, and new construction would all be classified as opportunistic.
Opportunistic investment often generates very little or zero cash flow from the offset. However, they present the opportunity for massive returns if structured and executed correctly. Market timing and experienced operators are crucial to the success of this type of investment.
Opportunistic investments usually generate returns in excess of 20% on an annual basis and the debt deployed on a deal can range widely from zero to 80+%.
Just like with any investment strategy it is important to match your return goals and risk profile with the appropriate investment strategy. I often see conservative or inexperienced investors pursuing value-add and opportunistic investments simply because they do not fully understand the risk involved. Fully understanding the downside of any investment is likely more important than understanding the upside Warren Buffets longtime partner, Charlie Munger, put it another way. “Instead of looking for success, make a list of how to fail instead. Tell me where I’m going to die, that is, so I don’t go there.”