Chasing Yield or Safe & Steady? Commercial Real Estate Investments on the Risk Spectrum

by Matt Mellott, CCIM

You’ve worked hard to to grow a portfolio that makes you money while you’re sleeping. When looking at investment alternatives, how do you decide what fits with your financial goals and for those of your family or your company? This applies whether you’re investing in commercial real estate in Missoula, in Montana at large, or across the nation and globe.

To understand your options, financial investments are generally placed on a spectrum demonstrating a range of risk vs. return options.

The US Government T-Bills, as seen on the graphic to the right under “Government Bonds”, is one of the lowest risk investment alternatives there is outside of holding cash. As of the publishing date of this article, the ten year treasury–a commonly referenced benchmark of low risk investments– sits at 3.022% .

Image credit: WEALTHIFY

On the other end of the spectrum you will typically find growth stocks, venture capital and private equity interests. These are generally not backed by hard assets or the full faith and credit of the U.S. government. But, while risky, their returns can significantly exceed other options on the opposite end of the spectrum.

Generally, commercial real estate (CRE) is located in the moderate risk territory between low risk bonds and higher risk stock, venture capital (VC) and private equity (PE) interests in business entities. The underlying  real property and income production from leases for CRE investments tend to mitigate some of the risk associated with vacancy, tenant failures, and physical maintenance costs. But, the possibility of adding value to certain CRE investments through re-positioning, improved management, or physical improvements gives CRE some of the entrepreneurial profits associated with stocks and PE investments.

Inside of the commercial real estate arc of investments, a mini-spectrum of risk also exists. These are typically broken down into Core, Core Plus, Value Add and Opportunistic commercial real estate investments.

On one end, typically referred to as Core assets, are stable, income-producing properties that are as close to passive investing as one can get when buying CRE directly. These typically make returns in the 7-10% range annually and are leveraged at 40% or less. They generally have little to no deferred maintenance.

Some examples would be single tenant, net leased (STNL) offerings to national credit tenants. A “credit tenant” is a tenant that has a bond rating through Moody’s or S&P —think Starbucks, Walgreens, Cigna, Target, etc. Or, they could be “A” quality, new, high-end, well-managed apartments in prime locations. “Trophy” assets, too, are considered Core. A great example of a trophy asset would be the Empire State building or Sears Tower in Chicago.

A 60% occupied office building close to downtown with deferred maintenance or some degree of functional obsolescence would be an example of a value add opportunity.

Core assets are usually classified as being in larger primary and secondary markets, so Missoula, Kalispell, Bozeman, Billings (and all of Montana) are typically not considered “Core.” However, it is not uncommon to hear owners and investors refer to similar style properties as Core assets even if they don’t strictly meet the consensus terminology.

“Core Plus” are properties with a low to moderate risk profile. The distinguishing characteristics of Core Plus is that they will often have the ability to increase net income through light property improvements, management changes or by upgrading tenant quality. In general, though, these properties tend to be high quality with low vacancies.

An example of a Core Plus asset would be an apartment building less than 20 years old in need of some minor upgrades to finishes and fixtures. These assets will generally “throw off” cash, but some of that cash needs to be held back for future capital repairs to roofs, parking lots, boilers, etc.

Core Plus investors often use leverage in the 40-60% range and anticipate annualized returns between 9 and 13%.

Commercial Real Estate Risk Spectrum by Asset Strategy Courtesy of: CROWDSTREET

Value Add is, much as its name implies, an asset with opportunities to grow the value of the property. These properties often start with low or no income, but present significant upside once value has been added by fixing occupancy issues, correcting management deficiencies and/or addressing deferred maintenance items.

A 60% occupied office building close to downtown with deferred maintenance or some degree of functional obsolescence would be a good example of a value add opportunity.

 

 

While the annualized returns in the 13-18% range sound attractive for Value Add opportunities, these investments require a professional-grade knowledge of real estate, planning and asset/property management. Leverage will often be in the 60-75% range and therefore exposes the buyer of this sort of asset to significant financial risk.

At the far end of the the real estate risk spectrum are Opportunistic assets. These are the riskiest of all commercial real estate investment strategies. These are generally projects with “hair” on them: complicated deals with no cash flow up front, including adaptive re-use projects and/or new development projects.

Opportunistic investors tend to use leverage of 70% or more and often use secondary funding sources such as mezzanine and hard money debt. In exchange for taking these risks, opportunistic investors expect to yield 20% or greater.

Given this range of options, how do you find your place on the spectrum? Or, more accurately, what is the correct allocation of your assets at different points along the spectrum to meet the financial goals of you, your family and your company? To make that determination, it is wise to consult commercial real estate professionals with experience in all of these asset strategies.

You’re invited to contact a Sterling CRE advisor to help build your investment portfolio with commercial real estate.

This is not tax or accounting advice. For tax, legal or accounting advice, please consult with a CPA or tax attorney.

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