Within the landscape of commercial real estate investment, an investor must make a myriad of decisions about where to deploy their capital. From asset class to market, project type, and capital structure, each decision is a plot point on the risk vs. return spectrum. For every choice that adds more risk to the equation, a higher return is required to compensate and vice versa. For every choice that reduces risk, the return is likely to be lower.
Each individual investor and investment firm has a different risk tolerance and a different set of beliefs that inform an investment decision. But, the decision to deploy capital into a specific project or deal shouldn’t be made in isolation, it should be made within the construct of a broader investment portfolio and strategy. Constructing a diversified portfolio of real estate investments requires that an investor consider project types at all points in the risk vs. return spectrum.
In this article, we’ll explain the difference between risk and return in real estate and outline the different types of commercial real estate investments and their associated levels of risk.
Risk & Return Defined
Before discussing the different types of real estate investments, it’s first necessary to define exactly what risk and return are and their relationship to each other in the context of building an investment portfolio.
Risk is simply defined as exposure to the possibility of financial loss or some other adverse outcome. Every investment has risk, but it can be managed proactively by recognizing it and implementing strategies to mitigate it.
Return is the amount of income or profit made on an investment. In real estate, returns usually come in the form of rental income, property appreciation, beneficial tax treatment, or some combination of all three.
The relationship between risk and return is simple: the more risk an investment has, the higher the return an investor expects to compensate for it and vice versa. The lower the risk, the lower the return.
When constructing a portfolio of real estate investments, one of the fundamental elements of risk mitigation is to diversify the investments across a series of categories like location, amount, asset class and … risk.
Risk vs. Returns: Types of Commercial Real Estate Investments
When thinking about the types of commercial real estate investments and their associated level of risk, it’s helpful to imagine how a pyramid is constructed. There’s a foundation, which is the widest part of the structure and sits at the base. It’s the most stable and must support the weight of everything above it. Moving up, each level gets successively smaller and more exposed until the top is reached, which is the smallest and most exposed portion of the structure. With this visual in mind, consider the following investment types:
Foundational Investments
Foundational investments are the bedrock of the investment portfolio. By definition, they are the most stable and least risky assets.
Foundational investments are characterized by low leverage, stable income, excellent locations, no major structural or operational issues and high or full occupancy with credit or national tenants. Foundational investments have a low risk of principal loss and generally provide a return in the 4% – to 8% range with low chance for significant price appreciation. These are the bread and butter assets that can be depended on for a stable return in the form of income. Examples include things like Walgreens drug stores or free-standing bank branches in high traffic locations.
Foundation Plus Investments
Think of Foundation Plus investments as those that are the second level in the pyramid. They are slightly riskier and their return consists of income plus a chance for some price appreciation.
Foundation plus investments are characterized by those with a good – not great – location, stable income, and some opportunity for price growth. The properties are mostly full and may have some leases coming up for renewal in which there’s an opportunity to increase rents. Annual return expectations for Foundation Plus investments are in the 8%-12% range.
Value Investments
Value investments are the middle of the pyramid and pose an increasing level of risk. Value properties may be located in marginal locations and have variable cash flow or high vacancies. In addition, there could be operational issues associated with inefficient or ineffective property management or the property may require renovations due to functional or physical obsolescence. Because the risk is higher, value investments can return 13% – 20% annually. However, the return mix is more heavily weighted towards price appreciation than income. An example of a value property could be a small retail shopping center that requires renovations and new tenants to be stabilized.
Speculative Investments
The top of the pyramid, and most risky investment type, are speculative investments. These should have the smallest level of portfolio allocation, but offer the highest potential for return.
Speculative investments may include assets that have significant upfront costs for renovation or repositioning or they may be ground up development where the investor could go months or years before receiving income. In addition, the long lead times for construction or renovation expose the investor to market, regulatory, and permitting risk which can cause extensive delays or alter the viability of the project.
On the flip side, speculative investments offer returns of 20% or more. Returns are almost entirely in the form of price appreciation due to the value added by the renovations or new construction.
Again, the key to constructing a diversified portfolio is to allocate capital to “each level of the pyramid” and to actively manage investments to mitigate risk. This requires a significant level of experience, expertise, and full time focus to accomplish.
First National Realty Partners – How We Can Help
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms with decades of experience in optimizing the risk/return characteristics of a portfolio. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
Through our decades of experience, we’ve established a consistent and repeatable three-step investment approach:
- Buy it – We acquire high-quality, income-producing assets at discounts to replacement costs
- Fix it – We rapidly and proactively address any capital structure, physical, or operating issues pertaining to the investment
- Exit – Once issues are addressed we refinance the investments and hold them for the long term. Our average hold period prior to refinancing is slightly more than three years
If you’re seeking a commercial real estate investment option and have a long term time horizon, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or [email protected] for more information.
