Real Estate Acquisitions: What Are Your Return Expectations?
Introduction
Commercial real estate investments are often categorized based on various characteristics of the deal. These segments are often defined as core, value-add, and opportunistic investment strategies. Each investment strategy has its own risk/return level, with core investments being the least risky and opportunistic investments yielding the highest level of risk. In between lies the value-add strategy that seeks to make improvements on an existing asset with existing cash flows. Every investment strategy has its place in the market, but it is important to understand each one’s characteristics before you implement it.
What are Core Investments?
Core investments are the highest quality assets with the most reliable cash flows due to properties’ longer lease terms, low volatility, quality construction, and location. Core investments are an attractive option for conservative investors because they allow for capital preservation and investment diversification, making them low risk. Core investments are generally established in primary markets and urban areas where the properties will consistently be occupied, therefore leading to more stabilized cash flows. Returns on core investments usually lie between 8%-12% with leverage up to 50%.
What are Value-Add Investments?
Value-add investors seek assets that are currently underperforming in comparison to the market. A value-add investor will look to improve or upgrade a property through physical modifications, occupancy, management, and operating expenses. All improvements can lead to an increased net operating income (NOI) which would directly result in a higher asset value. The capital structure for value-add investments generally relies on a medium to high leverage in order to finance all the upgrades/improvements of a property and increase returns. Value-add investments will often bear more risk than core investments, as the success of the investment is heavily reliant on the execution of the value-add plan. In the case a plan fails or does not meet the projected expectations, the investor could incur significant losses.
What are Opportunistic Investments?
Opportunistic investors generally target assets that are greatly underperforming in comparison to other assets in the market. Oftentimes, these assets have little to no cash flows at the time of acquisition. Some examples of opportunistic properties include empty buildings, distressed properties, or redevelopments where the buyer will demolish an existing structure and construct something new. Opportunistic investors often employ extremely high leverage to cover their high development costs and project time. These investors have uncertain exit assumptions as the Exit Cap Rate is not based on the Going-In Cap Rate. All these factors lead to poor debt terms and high-interest rates, further increasing the risk of the investment. However, opportunistic investments also have the highest expected returns for real estate investments due to the use of leverage and its amplifying effect if the project is successful.
Conclusion
All three investment strategies are commonplace, and each can produce good returns for the investor. When choosing between the three, investors should consider their investment timeline, risk tolerance, and expected return. In reality, a full spectrum of investments exists with varying levels of risk and return; the three categories simply serve as a guideline to organize different investments.
Before founding 3E in 2016, Managing Member Eric Bergin was Director at Rockpoint Group, where he was responsible for for the Finance Group, as well as acquisitions, asset management, and investor reporting activities.