Types of Risk-Adjusted Funds in Commercial Real Estate
Many articles within the Insights series discuss risks and uncertainties associated with real estate. Whether your goal is to develop real estate, own stabilized assets, manage properties, or one of the many other ways you can be involved in the industry, you must understand the risks involved with different strategies. This article will discuss four major categories of risk you may encounter throughout your real estate career: core, core-plus, value-add, and opportunistic. But before we get to the risk types, we need to first look at some of the factors you can use to better classify each type of risk.
Major Factors to Consider
The type of market in which a property is located plays a big role in determining the risk profile and liquidity of a property. There are several different ways markets are classified. Some separate markets into “Primary” or “Secondary” or “Tertiary” markets while others use a tiered measure (Tier I, Tier II, Tier III). We’ll use the primary, secondary, tertiary classifications in the remainder of this article. Keep in mind that there are no definitive rules for the classification of a market and different people can sometimes classify markets into different categories, but the descriptions below can offer some high-level guidance.
Primary Markets – Also known as “Gateway markets,” are major markets with large, dense populations and diverse employment and demographic bases. Examples of primary markets are New York City, San Francisco, Washington, D.C., Los Angeles, Miami, and several others. These markets have high levels of transactions and are the main targets of large investors such as pension funds, REITs, etc. due to their diversity and higher liquidity. Primary markets experience the lowest cap rates of the three types of markets.
Secondary Markets – Sometimes classified as markets with populations between 1 and 5 million, but less dense than primary markets with lower transaction activity. Examples of secondary markets are Austin, Nashville, Charlotte, Denver, and others.
Tertiary Markets – markets with less than 1 million in population, low density, and less diverse economic bases. Tertiary markets have the lowest level of liquidity and investment by major players, resulting in the highest cap rates of the market types.
Properties are classified based on their quality and functionality as either Class A, Class B, or Class C properties, with Class A being the highest quality. Class A properties are usually newer or functionally modern and offer a high level of quality and appearance. Class B and C properties fall down the spectrum on condition, quality, and functionality. Determining the class of a property can sometimes be tricky depending on the market and the competitive properties. A Class B property in a primary market could be a Class A property in a secondary market with a lower level of competition. The class assignments are often gray without clear identification of what falls in what category.
Stage of Lifecycle
Developments are typically more risky than an existing property that needs to be repositioned, and properties that need to be repositioned are generally more risky than a fully stabilized asset. Even a Class A property in a primary market can present a high level of financial risk if the vacancy level is extremely high due to a tenant recently leaving the building. Understanding where in the lifecycle a property falls is key to understanding the profile of the investment required in the property.
Types of Risk-Adjusted Return
We can start the discussion on types of risk-adjusted investment strategies by looking at the chart below that provides a visual breakdown of where each type of risk/strategy falls on the risk-reward spectrum, followed by descriptions of each of the categories.
Core – Core assets include the highest quality and most stable properties in the market with the lowest level of risk and lowest level of return. These are generally Class A properties with long-term leases and stable income, requiring very little active management by the owners. The major owners of core properties are large firms such as pension funds, insurance companies, REITs, and other major investment companies. Core assets usually have relatively low amounts of debt at around a 50% loan-to-value (LTV) ratio. This low LTV is illustrative of the low risk tolerance of the owners of core properties.
Core-plus – Core-plus is very similar to core assets, but with the ability to improve the performance or condition of the property slightly through repositioning or renovation. Repositioning could include filling some vacancy or transitioning the property to a base of higher quality, credit tenants to improve stability of cash flows in the future.
Value-add – Further to the right on the risk-reward spectrum are value-add properties. These are similar to core-plus properties, but includes properties that need more significant active management in order to bring the property back to stabilization. Value-add properties often have some income, but also have substantial vacancy issues or require a large amount of investment in capital and physical improvements to the property.
Opportunistic – Finally, opportunistic real estate investments are the most risky, but also potentially offer the highest levels of return for the effort. Examples of opportunistic investments in real estate are new, ground-up developments and the repositioning of fully vacant or distressed assets. These properties will often have no income at acquisition and will require several years of effort and large capital investment before income can be generated. Because of the effort needed to turn around this type of property, active management by experienced real estate professionals is recommended.
Choosing a Strategy
Given the types of strategies, the different levels of risk associated with each strategy, and the factors that determine the risk associated with each property, how do you choose which properties to pursue? And how do you decide which ones are too risky or too low return for your specific circumstances? The two major considerations to answer these questions are your level of experience and the availability/cost of capital you have access to.
Your experience level in actively managing real estate properties will play a large role in determining what property types you should pursue. If you have little to no experience in real estate, value-add and opportunistic investments can be extremely risky because you probably don’t know what you don’t know. Also, managing the renovation of a single-family home is vastly different than managing the renovation and repositioning of a major office building. While it’s good to always try to improve, be realistic about what you can do and recognize when the position of a property presents challenges you’re not prepared for.
The second consideration is the amount and cost of capital you have access to. Because core properties in primary markets are generally valued in the tens to hundreds of millions of dollars, there are very few investors/companies that can acquire and operate these properties effectively. In addition, large investors can own core properties in primary markets profitably in large part due to the low cost of capital they can achieve. Smaller investors usually have higher costs of both debt and equity, requiring that they pursue strategies with higher potential returns to offset the higher capital costs.
Investors should first determine their ability to manage and invest in properties and decide what level of risk they’re comfortable with. Once these factors are determined, the type of investment strategy can be determined based on the information we’ve discussed above. While parts of the risk decision are based on what you have access to, others are based on what you feel comfortable with. As your level of experience rises, you should gain a better idea of what you can do well and how you want to expand your investment options.