Four Categories of Risk & Reward
In a private equity property, assets are generally grouped into four major categories according to the investment strategy and perceived risk. These four categories are basic, more elementary, valued, and unoptimistic. The major difference in these categories is the risk and reward profile. Moving from one strategy to another is like climbing the ladder to take more risks, and theoretically, be compensated for that risk with a better return. In a private equity property, assets generally fall into four broad strategic categories. An investment strategy with a perception of risk. These four categories are fundamental, more basic, value, and opportunist.
The main difference among these categories is the risk and reward profile. Moving from one strategy to another is like climbing the ladder to take more risks. And theoretically, get compensated for that risk with a better return.
The core assets, considered the most secure, are at the bottom of the risk-reward scale. Core real estate assets are relatively stable assets in large subways, such as high-rise office buildings or downtown apartment buildings in New York City, Chicago, San Francisco, Washington D.C., or L.A. They are usually the best properties in the best places, with a high and stable occupancy rate and creditor renters. Core assets can be quite large and expensive and, as a result, are generally held by well-capitalized entities, such as REITs and other institutional investors. Because they are stabilized and are already reaching market rents, there is not a lot of value that an investor can add, which limits their positive side. However, in times of economic slowdown, they are usually the last to lose renters. As a result, because of a lack of value-added opportunities that also offer a low-risk profile, core investments usually translate into one-digit annual returns.
Leverage with Core
May vary between 0% and 50% of asset value and rarely higher. The reason leverage is weak with the core is that it is just not conducive to using a lot of leverage given its low unweighted returns. Taking advantage of core assets adds little leverage returns, which generally adds more risk than a return.
Core-Plus
Core plus strategic assets occupy the next step in the risk scale. Core-plus assets can share many of the same features as base assets with one or more exceptions that create additional risk. A few examples of these exceptions can include age or asset status, a lessening of the lessee's credit, or a less than exceptional than-exceptional location. The annual yield of these assets generally varies from 10% - 14%. Leverage with Core-Plus: 50% - 65% of asset Value.
Unleveraged returns on Core-plus
Assets are high enough to warrant leveraging to increase leverage returns. But leverage is usually limited to limiting risk and maintaining the overall risk-reward balance of a core plus profile.
Value-added
Value-added assets are one step closer to the risk-return line. Value-added assets typically have a problem that needs to be fixed, such as leasing to improve the high vacancy rate, renovation, or rehousing to improve the quality of the rent list. The buyer usually comes up with a specific business plan to upgrade an underutilized asset. One example is a mall that has lost a key tenant, like a grocery store or another large tenant. The buyer will be able to purchase this property at a reduced price if there is no anchor. If the new owner has an effective business plan for repositioning the anchorage space and bringing new renters to the property that would enhance the overall shopping experience, the new owner can make a substantial profit. Indebtedness with value-added: 65% - 85% of the value of the asset. Leverage returns on value-added assets are now sufficiently high to incentivize the additional use of leverage to further improve leverage returns. In addition, strategies to relocate and reposition, as described above, can often be capitalized mainly by additional leverage financed by the principal lender after closing, as the business plan is proven.
Opportunistic
Opportunistic assets are the last step to the top of the risk range. Such transactions are generally extreme recovery situations. Major problems must be resolved, such as vacancies, structural problems, and financial difficulties. Sometimes referred to as distressed assets, opportunist strategies can involve the acquisition of assets seized from banks, services, or the acquisition of the senior loan from a bank discount or services for possible foreclosure.
Opportunistic investment was abundant after the recession the audacious investors intervened to buy properties in trouble at a sharp discount compared to previous transactions. In some instances, opportunistic transactions require specific expertise to complete the adjustment, or the patience to wait for a market slowdown to implement a value-added strategy after tenant demand starts to reappear. Because opportunistic investing carries the highest risk and requires the most expertise, it can provide an annualized return of over 20%. Leverage with Opportunistic: 0% - 70% of asset value. Because of the upside-down nature of opportunistic strategic assets, they are often ineligible for many leverages at the time of acquisition. If you acquired a ticket, you purchased the leveraged portion of the transaction with a strategy to convert it into a small-cap asset. The wide range is because opportunist strategies depend heavily on cases.
Opportunistic assets may also begin with little or no leverage but find ways to leverage or increase leverage as the business plan is developed. Think of a situation in which you acquire a 100,000 SF vacant retail building for $3 million or $30/SF all cash which could be worth $18 million or $180/SF with a permanent NNN tenant on a long-term lease. However, this tenant will require $7 million in leasehold improvements and capital investments to attract them to occupy the property. With a lease signed in hand, you could apply to a lender, promising the building is not renovated as security, and secure a loan for the full $7 million required to carry out the tenant's installation work. Once the tenant is in occupation, you have one more basic asset.
Investors must understand the risk-reward relationship when discussing the four different types of real estate investing strategies. The level of yield should be proportionate to the level of risk. Investors should also be mindful of value-added and opportunistic transactions the proponent's expertise and ability to create and execute a business plan may be essential to a successful project. A well-balanced commercial real estate portfolio may comprise some or all these different investment classes, depending on the individual investor's risk tolerance.
In previous post: "What are Real Estate Risk-Adjusted Returns?"
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