In recent decades, commercial real estate has evolved into an institutional asset. During the last 30 years, it has accounted for less than 2% of an institutional portfolio and was primarily owned by mom-and-pop businesses. Now, having a solid commercial real estate investment strategy is crucial if you’re thinking of venturing into this industry.
But there is a great deal of change in the world today. Nearly 10% of institutional investment portfolios are now invested in real estate. So, is commercial real estate a good investment? Investing in commercial real estate requires a unique set of objectives, risk tolerances, and time horizons for each investor.
Investors with a shorter time horizon may prioritize passive income or cash flow over long-term capital growth. A more experienced investor may have a longer-term outlook and will be able to take some risks to build wealth over the long term.
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It is argued that there is no such thing as a one-size-fits-all commercial real estate investment strategy. Rather, it is preferred that investors invest in real estate that is consistent with various strategies and determine which is the best fit for their individual needs.
Also, investors should do their own independent due diligence before investing to make sure that an investment meets their individual needs (e.g. rental income versus gains in value), risk tolerance, and time horizon.
Although billions of dollars have poured into real estate since then, the core strategies around acquiring it have remained largely unchanged. There is a general classification of commercial real estate assets, as follows: core, core-plus, value-added, and opportunistic investments.
To build a diversified commercial real estate investment portfolio with the best risk-adjusted return profile, there are four main strategies that are essential. Below you will find an overview of each of these strategies.
Core investing is largely regarded as the safest form of real estate investment. This term refers to the acquisition and ownership of stable assets with high quality, low vacancies, and/or located in the best places to buy commercial real estate. Typical examples of this are Class A office buildings in New York City.
Real estate is often perceived as a relatively safe investment by core investors since it offers yield over appreciation. An alternative to bonds, these investments are backed by physical assets and have the added advantage of acting as inflation hedges as well. Most of the time, the internal rate of return (IRR) is less than 10%.
For investors with a short to medium-term time horizon who prefer income over capital gain and aversion to risk, core investments tend to be the best commercial real estate investments.
Typically, these investors are older and intend to preserve their capital through a hold strategy. Alternatively, they might be new investors just starting out in the real estate market.
In essence, core-plus investing is like core investing but boosted by a little something extra. In pursuing a core-plus strategy, investors seek out assets that are still fundamentally reliable and attractive but have the potential to add value to increase returns. The risks associated with these investments are higher such as upcoming lease expirations, or opportunities for value-added improvements like minor renovations.
Core-plus real estate investment strategy is also a buy-and-hold approach to real estate that involves investing in properties with slightly higher leverage, typically 55% to 65% of the property value. There are only 25% of private equity real estate investors plan to pursue this investment strategy in the next 12 months, making it the least common of the four.
Typically, a core-plus investment is suitable for investors who have a low appetite for risk and who have the patience and means to accept annual return fluctuations. A majority of these investors have a medium-term time horizon and are middle-aged.
The risk-return profile for value-added strategies is high, approaching medium to high for both. In these investments, significant execution risk is required to add value to drive enhanced returns, such as major renovations, repositionings, or lease-ups to stabilize the property.
The goal of value-added investors is to hold assets for 5-7 years, allowing them to execute their strategy and gain most of their return from appreciation over yield. In other words, they don't mind waiting until they receive a bigger check at the time of sale. Investors use this strategy to generate outsized returns (10-15% IRR) upon disposition by adding some value initially.
Leasing is often considered an essential component of value-added strategies. A good brokerage team can market effectively, attract strong tenants, and negotiate competitive deals to boost the value of the property when the disposition time comes.
With 55% of private equity investors planning to use value-added investments in 2016, this approach is deemed to be the most popular back then. The strategy is probably appealing to investors because it allows them to escape the extremely competitive prices in gateway markets for prime assets.
The highest risk-reward investment strategy is the opportunistic approach. Typically, investors who pursue this strategy buy properties that are in need of a substantial amount of work—typically due to renovations, high vacancies, or general market strength. In addition, new developments often fall into this category.
As mentioned, development deals are considered opportunistic. In addition, repositioning a building from one use to another, or even a completely empty building, also counts. Emerging markets are frequently home to properties like these.
The greatest returns can be obtained by getting rights to an asset, but there is also the greatest risk associated with it. Typically, the asset is held for three to seven years, with the objective of achieving a 15% IRR or more. The strategy is expected to be pursued by 45% of private equity real estate investors this year.
The most positive characteristic of a real estate investment is its low degree of risk. In terms of investing in commercial real estate, there are several other types of strategies, including distressed/debt, corporate/public, and securities or commercial mortgage-backed securities (CMBS). However, the above four represent the most common types.
It’s important to note that these strategies are mixed up by many investors, especially hedge funds and private equity funds, for the purpose of diversifying their portfolios and meeting different investment goals.
It can be intimidating to invest in commercial properties as a beginner. In spite of this, it does offer many advantages, including higher income potential, lower vacancy rates, steady cash flow opportunities, and high-quality tenants.
By doing your own due diligence and working with an expert, you can earn passive income through commercial real estate. To learn more about commercial real estate investing, visit our website or contact us at 949-881-7128 at Saint Investment Group today!
A master in Investment, Marketing, and Capital Raising.
Nic has honed his focus on the Real Estate and debt markets with Saint Investment Group and pursues large-scale Distressed Asset purchases with his partners and syndications.