Commercial Real Estate Investment Strategies
There are four primary investment strategies investors use when investing in commercial real estate. Those four categories are Core, Core Plus, Value Add, and Opportunistic.
Knowing the differences between them is critical when narrowing your investment opportunities to ensure it matches your risk level as well as the characteristics of the return on the investment.
The term “core” refers to real estate located in high-quality locations with high-quality tenants that are purchased with little to no debt. Core investments are almost as safe as bonds, but with much higher returns. Unlike the stock market, core investments hold up exceptionally well in business cycle downturns. An example of a Core investment might be a fully tenanted medical office building with long-term tenants, located in a high demand area.
Expected Returns: 7 to 11%
Use of Leverage/Debt: Low, <40%
Core plus real estate is similar to core, but not quite as high quality. The property might be in the suburbs or a secondary metropolitan area. It may include riskier asset types like self-storage, entertainment, medical offices, or student housing. Core plus investors are also looking to generate steady income, but are willing to take on a little risk for potentially slightly higher gains. The property might require some slight renovations, but they’re still very high quality and have great tenants. An excellent example of this would a multifamily unit requiring some light repairs and updates to maximize occupancy.
Risk: Low to Moderate
Expected Returns: 9 to 13%
Use of Leverage/Debt: 40 – 60%
This investment strategy is exactly what it sounds like. Value add investors are looking for the opportunity to increase the value of their commercial real estate investment. Often these properties will be moderately distressed in some way (physical deficiencies, poor management, high vacancy, etc.). Value add investors work to increase the occupancy and hope to sell it for a higher price.
A value add investor looks at the upside potential. Some consider this the best balance between risk and return because there is some cash flow, but with more significant upside for increased gains. An example of a value add investment might be an apartment building that hasn’t been renovated in a while, with rents below market. It hasn’t been managed well and currently has a 20% vacancy rate.
Risk: Moderate to High
Expected Returns: 12 to 18%
Use of Leverage/Debt: 40 – 80%
Most real estate professionals consider opportunistic investing and ground-up development as synonymous. Opportunistic strategies target highly distressed properties that require major renovations. They also involve the development of raw land into residential or commercial properties.
Opportunistic investments are very hands-on and require extensive strategic planning, upgrades, and development. Investors should expect potentially three or more years before any income is generated. Opportunistic investments are typically made with as much debt as a bank will allow. Risk takers will enjoy the potential of an Opportunistic investment. These are high growth potential properties, but also extremely high-risk investments.
While the risk is high, so is the potential for reward for the right investor. It is not uncommon for these types of properties, when successful, to provide more than 20% returns on an annual basis.
Expected Returns: 20+
Use of Leverage/Debt: 70% or more
Understanding the four primary investment strategies used in commercial real estate is extremely helpful when narrowing your investment opportunities. These terms are not exact definitions – real estate professionals use these terms liberally, and nobody agrees on the precise definitions. However, this is how real estate firms categorize investments as well as many real estate crowdfunding platforms.
Investing in commercial real estate is a great way to diversify your portfolio and can be very rewarding for any investor. The investment strategy you plan to use should ultimately align with your timeline, risk tolerance, and expected returns.