There are many misconceptions about real estate investing that cause potential investors to bypass worthwhile investment opportunities. The perception of risk is one of these common misconceptions.
For instance, real estate can be viewed as too high-risk when zeroing in on strategies such as quick fix and flips or new construction and development. Conversely, it can be perceived as too “slow and steady” when only considering a long-term buy and hold strategy.
The truth is that real estate as an asset class at large affords investors the opportunity to participate virtually anywhere on the risk/return spectrum. Given that real estate has arguably generated the best historical risk-adjusted returns of any asset class over the long run, it’s worth considering the various avenues to gain exposure to this investment category, and where you as an investor should aim to participate given your particular appetite for risk and return.
The key to accessing the right type of return on investment from real estate is understanding how to navigate the various types of real estate investments, each with unique levels of risks and opportunities. There are numerous elements that factor into the exposure profile of a real estate investment, such as the amount of debt used, market stability, existing condition of the property, and many more.
In this article, we will discuss the four main types of real estate investment strategies: Core, Core-Plus, Value-Add, and Opportunistic.
Core real estate investing is generally the most conservative approach, making it a suitable option for someone who is risk-averse and has a longer investment horizon.
Core properties typically do not require significant improvements, already have credit-worthy tenants in place, are in stable, developed markets, and do not require much active management from the owner.
The primary purpose of core assets within a portfolio is to generate stable cash-flows from the outset with modest appreciation in value over the long-term. Typically core investments utilize less leverage than other strategies: often only 50% of total project capitalization is debt in these transactions to reduce total financing risk.
Core-Plus real estate investing is a slightly more aggressive approach than Core, which increases the potential risk and return of the investment.
Investors interested in core-plus strategies are typically looking to increase the cash flow of a property through modest improvements and by increasing management efficiencies. Minor property improvements may consist of repainting the walls, installing new lighting, or replacing the carpets. Increasing management efficiencies could include lowering operating costs, partially billing back tenants for certain utility expenses, or simply raising rents through more sophisticated marketing tactics.
The cash flows of Core-Plus real estate investing tend to be less predictable than Core and it can often take longer from the initial investment date to when the project starts producing positive cash flow. However, the modest improvements give investors the potential to make a stronger return.
The next step in the spectrum of real estate investing risk and return is Value-Add investing.
These investments aim to improve cash flows by making more substantial physical improvements to the building and by improving management processes. Whereas Core-Plus improvements tend to be capital light and more operationally focused, Value-Add strategies tend to require capital intensive upgrades. Through these activities, the investor can reposition the asset, charge materially higher rents, and achieve significant appreciation in value over time.
This type of investing typically involves higher levels of debt, which allows investors to increase total returns in a successful project. Conversely, greater borrowings tend to harm total returns if a project fails to achieve its objectives, thereby increasing the risk in a Value-Add investment. Given the capital intensive nature of investment activities in Value-Add, these strategies take time to come to fruition and are better suited for investors that can wait patiently for an investment to start to generate positive cash flow.
Opportunistic investments are the riskiest category of real estate asset classes.
These strategies tend to be very similar to Value-Add, however, the initial state of the property is typically much worse and requires significant improvements. Opportunistic investments tend to be completely vacant at the time of purchase and may include undeveloped raw land or an existing structure that is intended to be entirely repurposed.
While Opportunistic real estate investments offer the highest possible returns (sometimes over 20%), they also create the highest level of uncertainty given the substantial up-front capital required with no cash flow until the property is fully developed. These strategies also often include development, construction, and market risk, requiring all three phases to perfectly align in order to achieve target investment outcomes.
Investments of this profile typically utilize the highest level of leverage possible, in order to maximize the potential return to investors.
Reiturn believes that there is a place for real estate in every investor’s portfolio. However, each investor’s financial goals, time horizons, and risk tolerance are of the utmost importance in determining what strategy makes the most sense for an individual; there is no one-size-fits-all real estate investment. Based on these factors, Core, Core-Plus, Value-Add or Opportunistic real estate investing could be a fitting solution to diversify your portfolio and gain exposure to real estate.