Are you looking to make modest investment gains, play it safe, or create wealth? All investments come with risk, but ideally the return is a direct reflection of the risk. I submit that Core real estate investments, despite their perceived safety, present similar risk as other real estate asset classes; and maybe even more in the current investment cycle, but their modest returns do not reflect their risk.
In the world of commercial real estate investing there are a multitude of product types and asset classes, but for the newly initiated, there are four primary asset classes to consider:
- Core – There are nuances, but it is it easiest to think of Core assets as being Class A office buildings or trophy buildings usually located in core urban markets, with very low vacancy, high rents, low tenant turn-over, and with national credit tenants. These are often considered the safest real estate assets to invest in because they are typically in good condition, easily marketable, usually in demand, cash flowing and provide steady distributions to investors. Core investors are typically seeking regular income distributions and expect a holding period of 7-10 years and 5% to 11% annualized returns.
- Core Plus – Core Plus assets are very similar to Core, except there may be opportunity to increase the value through modest additional investment, or because it is being purchased with more vacancy which allows the new owners to fill the vacancy with new leases ideally at higher rents. Core Plus investors are typically seeking regular income distributions and expect a holding of period of 7-10 years and 8% to 12% annualized returns.
- Value Added– Think of valued added as assets that may be past their prime, have poor management, high vacancy, or their current use is not the highest and best use. This gives the new owners the opportunity to invest in remodeling, putting stronger management in place, sign new leases, or re-position/ convert the asset to a different use i.e.… turning a single tenant office building into a multi-tenant office or a warehouse into a self-storage facility. Value Added investors typically do not expect much, if any, cash flow the first few years and only expect to hold the property for 2-7 years and hopefully achieve 12%-20% annualized returns.
- Opportunistic- The most common way to think of opportunistic is as new construction, highly distressed, an asset in foreclosure, with financial or ownership issues, or in challenging locations. Except for new construction, the investment strategy for opportunistic is very similar to value added. With new construction investors get the chance for significant returns because they are creating the income from scratch. These are typically considered higher risk, speculative investments and use leverage, but often the risk can be mitigated with pre construction sales and leases. Opportunistic investors do not expect cash flow and recognize a majority of their return will come from the back-end sale of the property, only expect to hold the investment for 1-5 years, and are seeking 18%+ annualized returns.
At Northstar Commercial Partners we have provided institutional and self-directed accredited investors with annualized returns of over 43% over the last 17 years and that is largely due to staying away from Core asset investments and staying true to a disciplined and methodical investment strategy.
If you think about it, there are only two things that can happen with Core assets: they can chug along and barely beat actual inflation, or they can fail to keep pace with inflation. Core assets do not have many options to remain competitive in a changing market without reducing the return to investors. If things go awry, such as increased competition from new building’s coming on the market, then there is an increased chance the national credit tenants will jump to the newer shinier property. The only option for the landlord is to provide rental incentives to keep them; meaning lower rents, free rent, or dollars to improve the tenant’s space. When a tenant does vacate, it is likely the landlord will forego rent for short period but also has to spend money for leasing commissions and possibly redesigning and/or refurbishing the space. The landlord was probably already charging the highest rent the market could support, so with each turnover the properties investment performance suffers.
If you are looking for relative safety and modest income, then a Core Asset may be a good decision, but if you are looking for growth and/or income beyond just trying to stay ahead of actual inflation, then you may want to consider the other asset classes defined above.
This post was written by Brian Watson, Founder and CEO at Northstar Commercial Partners. If you have any questions, feel free to comment below, or contact him at brian@northstarcp.com.