Core, Value-Add and Opportunistic Investing

Investing in commercial real estate (CRE) is not without risk. Will the building lease? Will the economy expand or contract? Will new construction add too much supply? Will financing be available to underwrite an acquisition? Will this location fall out of favor? Will building systems operate as expected? These questions represent just a small sample of the numerous considerations that investors confront when attempting to identify and quantify risk.

At the heart of investing in any asset — be it stocks, bonds, futures or real estate — is the importance of understanding the relationship between risk and return so investors can (potentially) receive more compensation as they take on greater risk. When investors contemplate the acquisition of a real estate asset, they perform a thorough assessment (due diligence) of numerous parameters relating to each building or project, so they can quantify the known risks (and prepare contingencies for unknown risks) associated with holding and operating the property.

In CRE, the risk-return spectrum is often delineated by three labels — core, value-add and opportunistic — that broadly identify the amount of risk associated with a given investment.

While it would bring comfort to some investors to have clear and definitive parameters around each of these labels, others believe this latitude is important because “in reality, these decisions are made along a spectrum,” said Tal Peri, head of U.S. east coast and Latin America for Germany’s largest open-ended fund, Union Investment Real Estate.

Peri, who invests primarily in core properties across all asset classes, noted that these initial labels are important because they indicate, generally, into what category an investment falls. As someone that gets hundreds of teasers each day from brokers marketing properties, the labels help Peri quickly focus on the risk spectrum (core versus value-add opportunities) that matches parameters for the fund for which he is deploying capital. While the risk-return labels are not used as binding markers on documents, they do set expectations about the broad risks and return an investor might except.

The three primary risk-reward categories for commercial real estate investments based on definitions by CoStar, the owner of LoopNet, are:

• Core.
• Value-Add.
• Opportunistic.

Core real estate investments are typically stabilized assets that generate reliable cash flow from top-tier creditworthy tenants that have committed to long-term leases. Because of these attributes, a core real estate investment typically garners the highest rents in a market or submarket (top 10% or so), and the property is usually at least 90% leased at the time of sale. The building and/or systems are relatively new and efficient; the design is attractive and functional; building finishes are top quality; and the property is in an accessible and highly desirable location or submarket. The building is new or well-maintained, so it does not require any significant near-term improvements or expenditures and it is generally one of the most liquid buildings in the market.

Value-add commercial real estate investments generally focus on properties with some in-place cash flow, with at least 60% occupancy at the time of sale. The business plan is to make improvements to the building in order to increase net operating income by increasing rental income, reducing operating expenses or both. Owners might add square footage, upgrade building systems, improve finishes, introduce new amenities or change property managers. The objective is to rejuvenate or elevate the asset, so it can command higher rents and attract quality tenants.

Opportunistic investments target nearly empty buildings or raw land that are purchased to be significantly repositioned or built from the ground up. With little to zero in-place cash flow, this is the riskiest kind of real estate investment. These projects can include significant design, engineering and construction costs, as well as legal fees to navigate rezoning and obtain entitlements, and brokerage fees to market and lease space or sell units. These projects are often highly leveraged and can take years to complete. However, such ambitious changes, when realized, can potentially yield substantial appreciation in value for those investors willing to take on these risks.