“In any market, in any country, there are developers who make money…” – Sarah Beeny (English broadcaster/entrepreneur)
Although it’s been a mild winter here in the greater NYC area, it’s exciting that we’re starting to enjoy some beautiful spring weather in between the ebbing cold and April showers. With spring comes optimism for the summer ahead and typically the busiest time of year for housing transactions. However, with a backdrop of persistently higher interest rates and home affordability having fallen to levels not seen since before the 2008 Financial Crisis, I’m not sure we should expect a record year for housing transaction volume.
Regardless, to the point of today’s quote, deals will still be made for those who know where to look, whether we’re talking residential or commercial real estate. And a “good deal” is relative to the eye of the beholder (aka buyer), as it also needs to be an appropriate investment for those involved in the transaction. As we touched on briefly in Part 4, there exists a spectrum of risk/reward within commercial real estate that ranges from “core” to “opportunistic” (with “core plus” and “value-add” sandwiched in between), and – within each of these profiles – there are many projects and property types to consider. We’ll head down that path now. Here we go!
Core
Core real estate holdings are the most straightforward of the bunch. Let’s call them boring in a good way. In terms of a risk profile, these are conservative. These are often high-quality properties in proven markets (e.g., tier-I cities) with high occupancy and relatively secure income streams already in place. Stability, consistency, and low debt are all common attributes of core real estate. “For example, a Walgreens drug store with a 30-year lease would be considered a core property, as would a large, fully leased office building in Manhattan with little to no deferred maintenance.”
The above-quoted article also makes a critical point which is the following: a high-quality property with a lot of leverage (aka high loan-to-value ratio or – said another way – a lot of debt vs. the property value) is no longer a core investment, as it then takes on an entirely different risk profile. Thus, there are a lot of gray areas across the real estate risk/reward spectrum, and various factors determine what’s core and what’s not. Property type and location are only two of several key pieces of information needed to determine whether something is a Core, Core Plus, Value-add, or Opportunistic investment.
Core Plus
You may be wondering, “what does the ‘plus’ mean?” If a core property essentially provides all of its return via income, core plus is where we add some growth potential into the equation. As tradeoffs are always something we want to keep in mind, that higher growth opportunity may come in conjunction with less current income.
Why would there be lower income and more significant growth opportunities? Great question! If a property doesn’t fit into the “core” category and instead bleeds into the “core plus” realm, then one or more attributes lead to that conclusion. For example, occupancy may not be as high as it could be, the tenants or property management could be better, or repairs could require some or all of the cash flow to be reinvested. Deferred maintenance (aka repairs/improvements that were put on hold for one reason or another) from a previous owner could very well mean “deferred cash flow” for the new owner. And depending on the cost and complexity of those improvements, an otherwise core investment could end up being a core plus undertaking or even moving into our next category: value-add.
Value-add
Value-add is where owners may need to get their hands dirtier and – you guessed it – assume even more risk, less (or perhaps no) current income, and generally more leverage than Core Plus at the time of purchase. While buying a piece of core real estate and collecting stabilized rents may not require a lot of experience, having a particular set of skills for and significant involvement in a value-add property can really, well, add value. And that increased value can be reaped via higher future cash flow and/or price appreciation (I’d generally say it’s “both,” as increased cash flow directly increases value…but that’s a topic for another day).
Opportunistic
We started covering examples of opportunistic real estate in Part 4 of this series. In this case, a project may begin as wholly undeveloped land. If you thought making improvements to an existing building sounded daunting, how about having to build the structure and plan the underlying infrastructure before that building even starts (“pre-development”)? This Crowdstreet article I referenced last time does a deeper dive into the stages and risks of opportunistic real estate, in case it’s of interest; those stages include pre-development (zoning/permitting), development (design/construction), lease-up (finding good tenants), and then exit (sale).
And there’s no requirement that one particular party manages the process from start to finish, so there could be multiple sales or control changes during a project’s lifecycle. And it’s very common to refinance a property at different stages to take advantage of the (ideally) higher valuation and reduced risk profile that comes with a project getting completed and leased (thus, the owner can obtain more debt at lower rates).
The bottom line
The previously cited Origin article goes so far as to assign annual return (IRR) and leverage target ranges to the four risk profiles, and I think that’s worth sharing here as a numeric summary:
- Core: conservative risk profile. Leverage of 40-45% and IRR target of 7-10% (mainly income)
- Core Plus: moderate risk profile. Leverage of 45-60% and IRR target of 8-10%
- Value-Add: moderately aggressive risk profile. Leverage of 60-75% and IRR target of 11-15%
- Opportunistic: aggressive risk profile. Leverage of 70%+ and IRR target in the high teens or even 20%+
Art vs. Science
A nuanced and precise understanding of what adjustments can be made to a property to drive returns is needed to back into accurate underwriting of a project and, ultimately, the price a developer is willing to pay for the opportunity to take on a given project. Experience is vital because – although it sounds like a straightforward equation to calculate a future value of a property based on some improvements – there’s absolutely an art to comprehensively analyzing how operations, financing, occupancy increases, structural enhancements, cosmetic upgrades, and materials/labor costs can produce the desired result. And that all assumes execution isn’t an issue.
I agree with today’s quote, as there are always ways to make money in real estate for investors with the right combination of skills, experience, and capital. However, many things can go wrong, and the ability to make ongoing adjustments is of utmost importance. The first thing an investor should determine is what type of risk they are willing to assume, and then ensure the risk profile of a given project aligns with their expectations.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
