Every seasoned commercial real estate investor knows that all investments are prone to risks. While real estate investing is not as risky as penny stocks, options, and futures, the sheer amounts involved mean that if things go belly up, you stand to lose a lot.
That’s why it pays to identify the kind of risks attached to each real estate investment vehicle before you ink a deal. Industry leaders created categorization labels to help investors identify the amount of risk each investment poses.
According to Tal Peri, head of U.S. East Coast and Latin America for Germany’s largest open-ended fund, Union Investment Real Estate, these labels help him focus on the losses spectrum that matches parameters for the fund he is deploying capital.
If you’re a new investor to the game, you might want to pay attention to the labels—they indicate under what category an investment falls. That might be the difference between scoring a great deal and losing money.
As usual, the higher the risk, the higher the investors’ returns. This article helps you understand the risk and returns involved in Commercial Real Estate Investments (CREIs).
Risk vs. Return
Before discussing the different categories of CREI’s, it’s first necessary to define what risk and return are and their relationship to each other in building an investment portfolio.
Risk refers to the possibility of financial loss or some other adverse outcome. It’s wise as an investor to put strategies in place to help you recognize and manage risk better.
Return is the amount of income or profit made on an investment. In real estate, returns usually come in rental income, property appreciation, beneficial tax treatment, or some combination of all three.
As mentioned above, the relationship between risk and return is the higher the risk an investment poses, the higher the potential profits. The reverse is also true.
Risk-Reward Categories for Commercial Real Estate Investments
There are four categories for real estate investment strategies as highlighted in the diagram. These contain the factors to consider when investing in real estate:
Strategy 1: Investing in Core Real Estate Assets
Many consider this a low risk real estate investment, and it rightfully takes its place near the low risk-low return spectrum.
Core real estate assets investment often consists of established high-rise office towers and apartment buildings. You will find them downtown in major cities like New York City, Chicago, and San Francisco.
Tenants in this category have excellent credits and commit to long-term leases. As a result, investors are guaranteed reliable cash flow, making it a risk-free investment.
The characteristics of core investments are:
● The buildings are relatively new, efficient, and well-maintained.
● Bears attractive and functional design.
● Has top-quality building finishes.
● The property is in an accessible and highly desirable location.
● Relatively low degree of leverage since they might range from 0-50% of the asset’s value, but rarely higher.
● Properties are fully or mostly leased (close to 90% occupation).
Suppose your primary investment objective is to protect your assets from a decrease in purchasing power while at the same time securing long-term wealth for your family. In that case, this is the investment strategy for your needs.
Core investments have a low risk of principal loss and generally provide returns in the 4% to 8% range. However, that also means they have a low chance for significant price appreciation.
In addition, the major reward to such investments is that a slowdown in economic activities won’t affect them since their tenants are financially stable and unlikely to face unemployment.
Strategy 2: Investing in Core-Plus Real Estate Assets
Think of core-plus as those in the second place, a step higher than core assets, in the risk ladder. That means it’s slightly riskier but offers better returns.
There’s increased opportunity since investors can renovate the properties and, in turn, hike the rent. However, there may be a risk and opportunity since the property may be in the suburbs and not fully leased.
The characteristics of such projects are:
● Historic building rather than new construction.
● Building in relatively poor condition.
● It faces a dip in tenant credit.
● The property is in a not-so-great location.
● There’s a slender opportunity for price growth.
Annualized leveraged returns on these assets generally range from 10% – 14%.
Strategy 3: Investing in Value-Add Real Estate Assets
Value investments pose a mid-level risk since they generally have a problem that needs fixing.
Value-add real estate projects incur a higher level of risk alongside the greater potential for driving operating revenue growth and capital value appreciation.
The potential for rental growth in such assets could be discovered by:
● doing moderate renovations to attract higher-paying tenants
● higher rental rates in the immediate neighborhood
● brilliant business plan to reposition the anchor space/tenant
● adding additional square footage
● upgrading building systems
● improved finishes and installing new amenities
● changing of property managers
Remember, the goal is to give the property a refreshed look and, in turn, attract quality tenants who would afford higher rent rates.
Since you put in more effort to execute this business plan successfully, these investments typically provide leveraged returns between 15–19%.
Leverage with value-add: 65% – 85% of asset value/cost. Unleveraged returns on value-add assets are high enough to entice further use of leverage to enhance leveraged returns further.
Strategy 4: Investing in Opportunistic Real Estate Assets
It’s the riskiest investment strategy. Most of the projects in this category are new developments that you have to build from the ground up. In other instances, it necessitates a total turnaround.
These projects can include significant design, engineering, construction costs, legal fees to navigate repositioning and obtain entitlements, and brokerage fees to market and lease space or sell units.
In addition, the major downside to opportunistic real estate assets is that investors could go months or years before receiving any income.
However, opportunistic investments offer more than 20% in returns due to the value-addition renovations or new constructions to a vacant lot.
Investors need to understand the risk and return relationship when scrutinizing a potential real estate purchase. The level of the return should be proportional to the amount of risk taken.
If you’re a risk-taker, and investing in commercial real estate makes you tick, it’s advisable to implement these investment strategies labels.
According to real estate gurus like Tal Peri, you should actively mark all potential investments using the labels to alleviate risk. Thankfully, the label strategies real estate investment risk analysis doesn’t require experience, expertise, and full-time focus to accomplish.