Content:
Within private equity real estate, properties are typically grouped into four primary categories based on investment strategy and perceived risk. Those four categories are core, core-plus, value-added and opportunistic. The key differentiator between these categories is the risk and return profile. Moving between those categories is a bit like stepping up the ladder in terms of taking on more risk, and in theory, the potential of being compensated for that risk with a higher return.
Note, however, that investing in commercial real estate entails substantive risk, including risk of total loss of capital, therefore all four categories do carry risk, and that all investors should consider risks specific to that given property prior to investing.
In this article, we’ll explain these four investment strategy categories and some key takeaways.
Core
Core commercial real estate (CRE) investments are generally considered to carry less risk in relation to other commercial real estate investment categories.
These properties are typically fully leased to high credit tenants (tenants with extremely good credit, typically major corporations), and generally require little to no major renovations. These properties are often located in highly desirable locations in major markets. With the potential stability, core holdings are generally not seen to carry as much risk as the other CRE investment categories, however, in turn, they tend to target lower annualized potential return to investors.
Core-plus
The term "core-plus" was originally defined as "core" plus leverage.
Core-plus properties usually require some improvements in order to increase net operating income (NOI), typically either by decreasing operating costs, raising rents, and/or renting to a higher caliber of tenant.
Core-plus commercial real estate (CRE) investments are often typically referred to as “growth and income” investments. Compared to other commercial real estate categories, the cash flow is generally less predictable, but typically they target a higher rate of return than core commercial real estate investments.
Value-add
Properties are generally considered “value-add” when they have some level of management and/or operational problems, require some physical improvements, and/or suffer from capital constraints.
By making physical improvements– for example, remodeling the apartments in a multifamily property, installing more energy-efficient heating systems in a medical office, adding cold storage to an industrial space, improving the quality of tenants, and/or lowering operating expenses, the owner can hope to increase the property’s net operating income (NOI). This in turn may increase the “cap rate” of the property, which is the rate of return based on the income that the property is expected to generate. This could potentially increase the overall value of the building when it sells.
Usually given the amount of work needed to enable the property owner to command higher rents, value-add properties tend to target higher potential returns to potentially compensate investors for the increased amount of risk.
Opportunistic
Opportunistic real estate investments are often considered one of the higher risk investment opportunities, usually requiring major development work. Opportunistic properties tend to need significant rehabilitation or are being built from the ground up.
Due to the increased level of risk, they often target higher potential returns to investors than other types of CRE projects, but they generally have little to no in-place cash flow at the time of acquisition and typically have a more complicated business plan.
Learn more about opportunistic investing: What is Opportunistic Investing?
Development
Wait, weren’t there four categories? Yes. But let’s cover a subset of opportunistic commercial real estate investments: development. Development usually has many moving pieces that cause these projects to be high on the risk profile. These risk factors may include pre-development risk (surveys, permitting, entitlement), vertical construction risk, arranging permanent financing, leasing, hiring property management, and more.
Development deals also generally don't provide cash flow during the construction phase, but when the property is fully constructed and stabilized they may generate income. Due to the increased risk, development projects often target higher potential returns than other CRE projects.
What are the takeaways?
It is important for investors to understand the risk and return relationship when discussing the four different types of real estate investment strategies. The level of the return generally commensurates with the amount of risk. Investors also need to keep in mind that the expertise of the sponsor and their ability to create and execute a business plan can be critical to the overall success of a project.
A balanced commercial real estate portfolio may include some or all of these different investment categories depending on the risk tolerance and the investment objective(s) of the individual investor. The CrowdStreet Marketplace offers projects across the risk spectrum in each of these categories. All investors should consider their individual factors in consultation with a professional advisor when deciding if an investment is appropriate. Investors should carefully review each offering in detail before making an investment on the Marketplace.