There are many characteristics of a real estate investment that Limited Partners (LP’s) should consider when evaluating whether or not they want to invest in a particular deal. Some of the things an investor should ask themselves before investing are; What’s my tolerance for risk? What IRR percentage do I want to achieve? What class of neighborhood/building do I want to invest in? Am I looking for steady cash flow or do I want higher overall returns? While each deal is different and there are many variables an investor must consider before investing, there are industry terms used to define the risk and return characteristics of a real estate investment. The terms or ‘buckets’ used are Core, Core Plus, Value-Add and Opportunistic. They range from conservative to aggressive and are defined by both the physical attributes of the property and the overall risk profile of the deal. In this month’s edition of The Harbor Drive Investor we will break down these four main categories of a real estate investment.
Core real estate investments are considered to be the least risky of any real estate investment. Core property investors are seeking stable income with very low risk profile. A core real estate investment usually uses the least debt leverage of any of these four investment strategies. Core real estate is located in strong urban demand centers of major metro areas (Los Angeles, San Francisco, New York, Washington D.C. etc.) and typically charge the highest rents. Core properties are usually new construction, built within the last 10 years and have many modern amenities for their tenants. Levered historical returns of Core properties range from 6-8% IRR.
Core Plus real estate investments are similar to Core but have a low to moderate risk profile with more potential for growth. Core Plus property investors are also seeking income but also want more upside (growth potential) than Core investors. A Core Plus investment uses even more debt leverage than Core which increases the risk profile. Core Plus investors can typically raise income and value of a property through some light property improvements, improving the quality of the tenant profile, or create management efficiencies. Core Plus properties are a bit older than Core and these properties might be located in the suburbs of a major primary metro, or well located in a secondary market. Leveraged historical returns of Core Plus properties range from 9-12% IRR.
Value-Add real estate investments have a moderate risk profile with big growth and income potential after the ‘value-add’ business plan has been executed. Value-Add investors are seeking higher returns than Core and Core Plus investors and are willing sacrifice cash flow early in the investment hold period in exchange for bigger growth potential and higher cash flow in the future. Value-Add real estate investments typically seek higher leverage debt to maximize the cash flow and available proceeds to spend on property capital improvements. These properties usually have either operational problems, occupancy issues, original finishes, deferred maintenance, or a combination of all four. Value-Add properties are usually even older than Core and Core-Plus and are located in the suburbs of major metros or in secondary and tertiary markets. Leveraged historical returns of Value-Add properties range from 13-17% IRR.
Opportunistic real estate projects are the riskiest of all four strategies. These investments also have potential for the highest returns to investors. These are complex deals with major problems, or land development projects. Opportunistic real estate investments use high leverage debt and need experienced real estate operators along with heavy oversight on the execution of the plan. Opportunistic real estate investors typically won’t see any cash-flow from operations for the first several years of the investment. In exchange for their high-risk tolerance, Opportunistic investors can be potentially rewarded with very high leveraged returns above 18% IRR.
What’s Your Appetite for Risk?
Regardless of your risk tolerance or investment goals, it is important for you to understand what type of investment you’re looking at when you are considering investing in a real estate syndication. Be sure you ask the sponsor of a deal you’re looking at which of these ‘buckets’ the project falls into. Please reach out if you would like to discuss this or any real estate topic in more detail, as we would love to hear from you! Also, don’t forget to visit our website and check us out on social media using the icons here below!