This is a guest post from Millionaire Mob, where people come together to find the best travel deals and financial advice. They specialize in dividend growth investing, passive income, and travel hacking. Their advice has helped thousands travel the world and achieve financial freedom. Follow them on Twitter, Facebook or Instagram.
Investing your money wisely is all about asset allocation and risk tolerance. But risk is personal. It’s rare that any two investors will have the exact same appetite for risk and, depending on your financial status, your own opinions regarding risk might change from year to year.
When it comes to commercial real estate (CRE), different properties carry a different amount of risk, dictated by a multitude of factors including general market risk (the overall economic environment), asset-level risk, idiosyncratic risk (things specific to that property), liquidity risk (how easy is it to get out of an investment) and more. One of the most “risky” CRE investments is in opportunistic properties.
What is opportunistic real estate investing?
Generally speaking, opportunistic investing involves investing in misunderstood and/or deeply undervalued. “An opportunist buys things because they’re offered at bargain prices,” says Oaktree Capital Management’s Howard Marks in The Most Important Thing. As it pertains to real estate investing, opportunistic investing means investing in a property that needs significant rehab work to reach its full potential market value. Sometimes referred to as “Distressed Assets,” opportunistic CRE investment strategies may involve acquiring foreclosed assets from banks, or acquiring the senior loan at a substantial discount from banks. Sponsors for these projects are often subject to less favorable debt terms and higher interest rates than those with more stabilized properties. These projects tend to offer the highest level of return (if the business plan is successful), but also come with the most risk for investors.
These are some of the most important risks to consider while evaluating opportunistic real estate investments:
Execution Risk
Execution is paramount with opportunistic real estate investments. Why? Because these types of investments are significantly more complicated. Opportunistic real estate investments often require a complete overhaul of the property, structure, land, etc. These investments have a lot of moving parts and a lot of opportunity for something to go wrong–supplies cost more than expected, improvements take longer than planned, the sponsor runs out of time or money. As an investor, you want to ensure the sponsor has a strong, detailed improvement plan upfront. The more detailed, the better.
Management Team
Management team certainly goes hand-in-hand with execution. You’ll want to be sure that the sponsor’s management team has experience working in distressed or opportunistic type opportunities with a proven track record of success. There are a lot of nuances when managing an opportunistic property that simply doesn’t exist with a core asset, and the only way to learn how to navigate those challenges properly is to have handled it before.
Capital Structure
Opportunistic transactions tend to have higher levels of leverage and may have other forms of capital beyond equity involved, including mezzanine debt and preferred equity. It’s important to know where your investment falls in the capital stack as that will determine how/when you receive your distributions. If you are an equity investor in an opportunistic real estate opportunity with significant tranches of debt ahead of you, you need to know how that will affect your cash flow so you can plan accordingly.
Bankability and Backstop
Another component to the risk profile of opportunistic real estate investing is the bankability of the sponsor. In the event of a downside scenario or cost overruns, you want to ensure that you are working with a sponsor that could execute on these overruns (or find a proper solution for them) and not have to raise even more money from investors in order to keep the project running. Essentially, does the sponsor have enough of their own money in the bank to handle unexpected costs?
Timing
Studies have shown that these types of investments are actually less risky earlier on in the lifecycle and are riskier as time goes on. In order to mitigate this risk, you want to ensure the quick, efficient execution of a proper plan upfront. If the plan is carried out successfully upfront, the asset becomes de-risked and stabilized over time.
Let’s look at three examples to understand how you make the right decision from a numbers perspective. In the below scenarios, we assume that we purchase a building for $100 million. Each building purchase corresponds to the investment strategy.
- Core Plus: We assume that the sponsor used 50% debt leverage, so they raise $50 million of equity. The cash flow is based on a 7% cap rate on your equity. We see a modest bump in value appreciation at an exit in year five from debt repayment.
- Value Add: We assume that the sponsor used 60% debt leverage, so they raise $40 million of equity. The cash flow is based on an 8% cap rate on your equity. In year three, they make operational additions to improve cash flow to 9% cap rate off our initial cost of equity. They then sell the stability asset for a 7% cap rate.
- Opportunistic: We assume 70% debt leverage, so the sponsor raises $30 million of equity. There is no cash flow in the first two years and the investor pool to invest $2 million of additional equity to improve the building. From there cash flow increases and stabilizes by year five, and then the sponsor sells the asset.
As you can see from the scenarios above, opportunistic relies heavily on leverage, operational improvements, AND a favorable exit.
What drives the risks? The real quantitative risks with opportunistic real estate include:
- Appropriate exit environment: While you can provide value under your own control, there are matters that you just can’t control. Given that much of the return is driven off the exit, you are much more sensitive to the timing of when the sponsor ultimately decides to sell the property.
- Execution: You aren’t investing for interim cash flow. You are investing under a kind of buy-and-lip mentality, where the majority of your returns come after the sale of the property.
Opportunistic investing is a great way for real estate investors to gain exposure to a value-add strategy that can have very favorable risk-adjusted returns, but opportunistic investing isn’t for the faint of heart or beginner investors. The best suited opportunistic investors are highly experienced, savvy investors that understand the full real estate investment lifecycle.
