Real Estate Investment Strategies
An introduction to the four main investment strategies
When it comes to real estate investments there are four fundamental strategies that should be considered. Although there are sub-strategies associated with each of these main strategies, the purpose of this post is to give you a general overview of the main four so that you have a good grasp of your options when presented with a potential investment property. To preface, there is no one right or wrong way to go about your investment strategy. The decision to use one over another is contingent on many factors. A few of these including financial capability/flexibility, your risk tolerance, and your long term investment schedule (long/short term), amongst others. Just like any investment, the capabilities and needs of the individual investor dictate the direction one will take on their position with the investment. Without further ado, here are the four main strategies everyone should weigh when investing in real estate:
Considered the safest type of real estate investment as it sits on the bottom of the risk-return profile and involves the lowest amount of risk. These are relatively stable assets that are typically located in prime locations in major metropolitan cities. These assets include the Big 4: Office, Retail, Apartments, Industrial. Overall, they are like a BMW or Mercedes in the real estate industry – best-in-class properties in the best locations. The tenants that occupy this space are typically in good credit and the buildings throughout have stellar occupancy ratings. During times of economic downturn, the tenants in these spaces are usually the last to leave – making it very stable. This factor alone makes Core properties a more stable investment than stocks. These investments are typically very large and very expensive, which is the reason why the majority of Core investment properties are owned by REIT’s and other institutionalized investors. Due to the low risk profile, the typical return on these properties are in the single digits (7-11%). These types of investments use the most conservative leverage (0-40%), and in some cases leverage can add unnecessary risk to the investment.
There are not too many differences between Core and Core + properties. They share many of the same characteristics, however Core + has a few exceptions that add risk. Some of these exemptions include the asset being older in general with the overall condition of the property being less than stellar. These properties in general tend to be located in the suburbs with some located in urban areas, albeit secondary metro areas. The tenants in these spaces may not be as high quality as Core properties, meaning their credit may be just sub-par and they may not have a rent guarantee from nationally renowned companies. As mentioned above these property types are typically those associated with higher risk such as a self storage building, entertainment, medical offices, or student housing. Core + properties on average are looking at returns ranging from 8-12%. It is important to keep in mind that Core + properties will experience losses before Core properties, and if this is the path you decide to choose you should account for this. Lastly, the higher returns justify the use of leverage, which typically can be anywhere from 40-55% of the assets value. However, leverage is still limited in order to preserve overall risk-return balance.
These properties typically are deemed “distressed” and need some sort of fix-up in order to reach their full potential. The “distressed” title can be derived from leasing issues, to significant vacancy, to neglected maintenance, etc. The main goal for the investor in this case is to do whatever he/she can in order to improve the vacancy issues present and improve the overall quality of the rent roll. General value-added strategies involve purchasing real estate at a lower price because it is moderately distressed in some way, getting a loan to improve it, and selling it for a higher price that exceeds the costs as a profit. Typically an investor approaches a value-added property with a preconceived business plan that will alleviate the issues associated with the property. A great example of a value-added situation is if a shopping center loses its anchor tenant. An anchor tenant is typically a well-known brand such as a Whole Foods that pulls the majority of the weight in attracting customers to the entirety of the center. An investor can see value-added potential in this center and should formulate a business plan that is focused on repositioning the anchor space. Finding one significant tenant or two anchor tenants to split the original space can go a long way in improving the overall shopping experience in the center and ultimately attract more people. An investor can make serious profit from a business plan like this. However, it should go without saying that this type of investment is typically moderate to high risk and requires a great deal of leverage to carry out. Leverage in this situation can range anywhere from 40-70% of the asset value, which does make the investment more susceptible to loss during a real estate downturn. Timing in this case is crucial. However, if everything is planned appropriately and the proper due diligence is made, returns can be anywhere from 10-15%.
The properties that require the most work to achieve full potential. Opportunistic properties are typically extreme turnaround situations. They are more plentiful during the wake of recessions as investors hurry to make major improvements before demand for properties begin to grow again. There are usually major problems to overcome such as total vacancy, structural issues, or financial distress. A lot of times opportunistic investing requires the development of raw land, which entails long periods of construction where no income of any sort is being generated. Your potential income thus is dependent on the quality and efficiency of the construction, which inherently is a project with high opportunity cost. This is why the majority of the return (70-100%) comes from the appreciation of the property, rather than direct income like the other strategies mentioned above. Hence, opportunistic properties are the riskiest one can find. Because of this high risk, these projects require special expertise on behalf of the investor in order appropriately time the acquisition, construction, and re-tenanting of the property. If all is done right, returns can range anywhere from 12% and up. Due to the distressed condition of these properties, they are usually ineligible for much (if any) leverage upon acquisition. The broad range is due to the fact that opportunistic strategies are highly case dependent. Opportunistic assets may also start with little to no leverage but find their way to leverage/increased leverage as the business plan develops.
Along with these four strategies we just wanted to include a simple graphic that shows the overall risk-return profile, as a visual can go a long way in understanding the degree of risk associated with each strategy:
*There are slight differences in strategy when it comes to commercial vs. residential investments. Again, the purpose of this post is to introduce to you the four main strategies associated with real estate investing. Variations between the two property types are something that we will get into in more detail in later posts.