What investment goals/metrics are right for you? Just like there are no two personalities that are alike, there are no two investors that are alike. In terms of what’s right for you, I can’t answer that question, but I can lay out the investing landscape for you to assess for yourself the right strategy for you.
The beauty of passive commercial real estate (CRE) investing is the flexibility it affords investors of all types to find opportunities that meet their particular investment objectives and risk tolerances. I believe that three of the most relevant factors for developing an overall investment strategy are:
- Type of return
- Risk-return
- Timing
You will find that a discussion of any one of these factors will regularly spill over into a discussion of one or more of the other factors.
Type of Return
Are you seeking steady, stable cash flow or are you willing to forego the security of fixed income for potentially higher long-term yields from appreciation? The decision to invest for income or growth ultimately boils down to an investment in debt vs. equity.
Debt
For investors seeking consistent, stable cash flow, an investment in debt instruments such as notes and certificates paying a fixed return over an established term achieves this goal. In addition to fixed income, holders of debt instruments – as creditors of the company – have added security in their investment through their priority over equity to claims in a liquidation.
Equity
Equity interests in a company through stock ownership in a corporation, partnership interests in a limited partnership, or membership interests in a limited liability company entitles investors to a share of company profits as well as potential voting rights depending on the terms of a particular offering. Although not guaranteed a fixed income, the potential returns to equity investors from appreciation are typically uncapped.
Hybrid
For those seeking both income and appreciation, preferred equity may be a suitable option. A common feature of real estate syndications is the offering of preferred equity that entitles investors to first-dollar profits through an annual preferred return along with a share of current and future profits. The preferred return, which pays first-dollar profits to the holders of preferred equity before any other equity holders, is meant to mimic the fixed income feature of debt by paying a fixed annual return based on a percentage of an investor’s capital account.
Timing
Payouts from debt offerings typically commence almost immediately after funding an investment but are usually of a shorter duration than their equity counterparts. Typical debt terms consist of 12-36 month terms. Equity offerings on the other hand, typically have longer lockup periods – typically a minimum of 5-7 years. Payouts from equity investments could potentially take longer to kick in as well – depending on the type and condition of the property and the investment strategy undertaken by the sponsoring company.
Risk-Reward
There is an investment strategy for investors with all types of risk tolerance and expectations of returns along with the risk-return matrix. Commercial real estate investment strategies fall into one of four segments according to risk, quality, and potential return: Core, Core-Plus, Value-Add, and Opportunistic.
Core: Low Risk (Potential 7-11% annual returns)
Core investments are typically low-risk and require no improvements or active management. It’s as close to a turn-key investment as you can get in the CRE world. Along with the low risk, they also offer lower returns than the other investment types. These properties generate stable, consistent cash flow from established, high-quality tenants locked in with long-term leases. For example, a national drug store with a 30-year lease would be considered a core property. Core properties require little to no maintenance, with most under NNN or NN arrangements. The majority of expected return is generated mostly from cash flow as opposed to appreciation.
Core Plus: low to moderate risk (Potential 8-12% annual returns)
Unlike Core properties, Core Plus properties offer the ability to improve cash flow through slight property or management improvements or by improving tenant profile. Core Plus properties tend to be of high-quality and well-occupied from the get-go.
Unlike Core properties that are occupied by long-term, established tenants, Core Plus cash flow is less predictable with more diverse tenants and these properties require active management by ownership. A 10-year-old apartment building with a good track record of occupancy and the quality of tenants in need of light upgrades is an example of a Core Plus investment opportunity. Core Plus properties will generate higher rates of cash flow than Core properties but some of that cash will be needed for deferred maintenance. And unlike Core properties, a higher portion of the property’s expected return will be generated from appreciation because of the property improvements.
Value-Add: moderate to high risk (Potential 10 to 15% annual returns)
Value-add properties when acquired underperform in terms of cash flow and occupancy but have the potential to see big bumps in occupancy and rents and as a result, cash flow, once the value has been added. At acquisition, most of these value-add properties have occupancy issues, management problems, infrastructure and maintenance problems, or a combination of all three. These investments require real estate expertise, strategic planning, and active management. Total expected returns are generated both from cash flow and appreciation.
Opportunistic: high risk (potential 20%+ annual returns)
Opportunistic investments are the riskiest of all types of CRE investment strategies. Opportunistic properties involve the most complicated projects like ground-up developments, land development, repositioning a building from one use to another. Opportunistic investments typically involve dealing with entitlement, zoning, and rezoning issues that can last for years. As a result, investors may not see a return on their investment for three or more years. Opportunistic properties have the potential to generate annual returns in excess of 20%.
Passive CRE investments offer investors of all types a variety of investment options across a broad spectrum of variables and factors including the type of return, timing, and risk-return profile. Where you find yourself on this spectrum will determine the investment goals/metrics that are right for you.
One investor more interested in immediate cash flow along with security if things go bad will likely lean towards a debt investment focused on core strategies; whereas another investor looking for a big payoff with the patience to wait for that payoff may be more attracted to equity investments incorporating opportunistic strategies.
For those looking for something in between, a hybrid structure involving preferred equity in value-add opportunities might be more suitable. Ultimately, only you can decide the investment goal or metric that is right for you.