Private Commercial Real Estate Strategies, Risk Levels, and Returns

The relationship between risk and return is a fundamental principle that reflects the trade-off investors face when making investment decisions. Generally, higher targeted returns are associated with higher levels of risk. Investors demand compensation for taking on additional risk, expecting greater returns in exchange for the possibility of greater losses.

Private real estate equity investing is dynamic and multifaceted, with various risk and return profiles depending on the location, property type, business plan, and market conditions of specific real estate investments. Understanding these risk and return attributes is critical for investors to make informed decisions and develop appropriate investment strategies^[2]. ^[3]

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Core Investments

Risk Profile^[4]: Low

Net Return Profile: 6% - 9%

Core real estate investments are typically associated with stability, reliable cash flow, and lower risk compared to other investment profiles. Assets are typically high-quality, well-occupied, income-generating assets in prime locations and supply-constrained markets with low leverage.

The business plan for core investments focuses on the optimization of operational efficiency. This risk profile aims to maintain consistent cash flow through high occupancy, enhance property value through minor, strategic improvements, and minimize risks. Core investments are typically held for a longer time horizon, typically 10+ years.

Examples of core investments could include well-occupied new construction multifamily assets in primary markets, or new construction industrial assets leased to credit tenants (or tenants that have investment-grade ratings by recognized rating agencies) for 10+ years.

Core-Plus Investments

Risk Profile: Low - Medium

Net Return Profile: 8% - 11%

Investors pursuing a core-plus strategy seek assets that offer in-place cash flow, with some minor upside potential through capital appreciation. Assets are typically high-quality, well-occupied, and in a highly liquid market, but may have some upside potential through minor lease-up, capital expenditures, and/or operational improvements. Such projects can include minor improvements to (1) the tenant base through lease-up or releasing, (2) the physical asset through capital expenditures, or (3) management strategies through revenue management enhancement (increasing occupancy or revenue) or expense reductions. Target hold periods for core-plus investments are between 5 to 10 years.

Examples of core-plus investments could include multifamily assets built in the last decade requiring light capital expenditures, or newer vintage industrial assets with strong in-place occupancy, which would require renewing or re-leasing part of the tenant base over the hold period.

Value-Add Investments

Risk Profile: Medium

Net Return Profile: 11% - 13%

Value-add investments typically focus on upside potential through price appreciation, with a focus on absolute returns (IRR) over cash yield during the hold period. These investments may be acquired with a more extensive business plan in mind to achieve elevated absolute returns compared to Core or Core Plus investments.

The business plan for value-add investments usually involves heavier renovation, lease-up, revenue optimization, or redevelopment to enhance the property's value. An investor may acquire an asset that is not well occupied, mismanaged by the existing owner, or is in need of significant capital expenditures. As such, in-place cash flow may be more limited, but the opportunity exists to increase cash flow substantially and sell the asset.

Examples of value-add investments could include acquisitions of older multifamily assets in need of significant capital expenditures (renovation), or the acquisition of an industrial asset with near-term tenant expirations and the ability to increase tenant rents upon rollover. While all investments carry some risk, if the business plan of a value-add investment is not successfully implemented, the project could be at risk of yielding low or even negative returns. Value-add investments are typically held for 3 to 5 years.

Opportunistic Investments:

Risk Profile: High

Return Profile: 14%+

Opportunistic investments carry a higher level of risk and, in turn, offer the greatest potential for returns, driven primarily by capital appreciation with limited or no in-place cash flow. These investments involve ground-up development or more substantial repositioning efforts often associated with underperforming or distressed assets.

The goal is to create substantial value through active management and capital improvements, generating high returns upon exit. Opportunistic investments are typically held for a shorter time horizon, around three to five years, with the strategy of selling upon completion of the business plan.

Examples of opportunistic investments include, but are not limited to:

• Ground up development: Building residential communities, commercial complexes, or mixed-use developments from the ground up. The risks in this strategy include the complexities of construction and the unpredictability of lease-up.
• Repositioning or adaptive reuse: Repurposing existing structures for a new use or significant lease-up. For instance, a heavy renovation and re-branding of a hotel could be considered an opportunistic investment.
• Distressed assets: Acquiring properties facing financial distress, foreclosure, or bankruptcy, and implementing strategies to turn around the distressed asset, such as renovations or rebranding. For instance, purchasing a foreclosed office asset, renovating it, and repositioning it in the market is considered a distressed investment.

Conclusion

Private real estate investors must align their risk tolerance, financial goals, and investment strategy with the appropriate risk profile. Whether seeking stable income, aggressive returns, or a combination of the two, an understanding of the nuances of each risk profile is essential in making informed decisions in the complex world of real estate investment.