Real estate investment strategies are commonly divided into four categories: core, core plus, value-add, and opportunistic. These strategies are differentiated based on the level of risk tolerance and expected returns for the project profile of investors.
Additionally, real estate investment strategies are also used to determine the risk-reward characteristic of real estate opportunity. Successful investors should make their own assessments and identify the appropriate investment strategy when analysing real estate deals.
Core investment strategy and core real estate
Core investment strategy is a conservative investment approach. The fundamental objective of core strategy is long term stable returns by operating core real estate assets that generate a stable cash flow with little need for further redevelopment or restoration.
Core real estate are premium properties that are strategically located in metropolitan areas, and are occupied by high quality, credit-worthy tenants on long term leases. These properties typically do not require physical improvement or development from investors. Examples of such investments include luxury hotels in city centres, prime office buildings in business districts or retail malls in the heart of the capital.
Core investment strategy has a low return, low risk nature. According to The Real Estate Crowdfunding Review, core strategy investors typically expect a 7%-11% annualised return for their investments at a projected level.
This strategy is suitable for investors who are risk averse and seek to employ minimal leverage to generate a constant cash flow. It is also suited for passive investors seeking a steady long-term income for their future goals or retirement funds, and prioritising capital preservation in long hold periods rather than gaining short term profit.
Core plus investment strategy and core plus real estate?
The concept of core plus strategy is similar to core strategy where both strategies target high quality real estate assets with long term leases. However, core plus strategy is slightly more aggressive as it positions investors into higher risk investments.
Core plus real estate are low-to-moderate risk investment properties that are in secondary metropolitan areas, where there is high growth potential, with the ability to generate returns with some light physical or strategic improvements. Core plus properties are often occupied by resilient tenants with long term leases but not quite as high quality as those in core assets.
Unlike core assets, core plus real estate may require investors to implement light physical improvement or enhance management efficiency to improve cash flow. Core plus real estate investors can expect a stable rental income and modest capital appreciation from their investment. Some examples of such real estate include entertainment centers, medical offices, student accommodations and self-storage spaces that are performing sub-optimally and have room for improvement.
The use of leverage for core plus assets is typically higher and cash flow tends to be less predictable. As a result, core plus investment strategy is suitable for investors who can tolerate moderate risk and expect higher return. According to Bullpen, a commercial real estate consulting company, “Investors in Core Plus properties expect a 9% to 13% annualized return”, and the leverage used by core plus investors is 45% to 60% of the property value.
Advantages of core investment strategies
1. Hassle free and lower fees
Investors are not required to dedicate a great deal of attention on managing such properties. As leases are generally long term, investors are not actively involved in the day-to-day operation of the properties since they may engage third-party property managers to perform these duties.
Core real estate are usually class A properties constructed using top grade materials. These properties are often well maintained by property managers or well cared for by tenants, depending on the leasing agreement. Thus, core investors spend little to none on renovation when they acquire such properties. Furthermore, long term leases also mean that most of the properties’ maintenance fees are directed to the tenants.
Investors using the core investment strategy tend to use less leverage when acquiring such properties. This means lesser acquisition fees and interest fees.
Given the underlying high-quality assets acquired, core real estate investments tend to exhibit a more consistent performance throughout the business cycle and hold up better during economic downturn.
Thus, core real estate are investments that provide investors predictable returns with relatively low risks. Such investments generally do not experience significant appreciation in capital value and will preserve its value throughout the business cycle in a stable market.
3. High liquidity
Core real estate are considered to be the most liquid when compared against value-added and opportunistic properties. As core real estate are usually the best-in-class properties located in high demand areas, they are deemed to be popular, attractive, and marketable assets.Sign Up at RealVantage
Disadvantages of core investment strategies
1. High entry barrier
Core real estate assets are usually large and come with high price tags, such as fully occupied office buildings in core international business cities. Therefore, a majority of participants in the core real estate market are well-funded entities such as REITs and institutional investors. Individual investors with limited capital will find it challenging to access core asset deals.
According to Preqin, a research survey company, “the smallest group of investors, those with total assets of less than $250 million, are least likely to invest in core real estate funds. In contrast, the largest group of investors, those with $10 billion or more in total assets, are most likely to invest in core funds, with 80% making investments in this type of fund.”
2. Limited control
Core real estate have fixed market rents. Investors will find it difficult to add value into core properties to further increase rental income. This will result in core assets losing their competitiveness in a changing market. For instance, if a new building with a more competitive rental price enters the market, there is a high possibility that tenants will be tempted to move to the new property instead of renewing their lease. When tenants vacate, it is likely that the owner will lose rental income for a short period of time and incur money on leasing commission, repair, and administration.
As huge expenses arise when tenants leave core real estate, it is in the best interest of investors to provide incentive to retain tenants. Such incentives include lowering the tenants’ rents or providing rent-free periods.
Metrics to use when assessing core real estate
When investing in real estate, it is important for investors to understand the relevant metrics to evaluate a potential investment. As core assets are income-driven and cash intensive projects, the following three matrices give a clear picture on the risk level and profitability of the project:
1. Cap rate
Cap rate is the ratio between the amount of income generated by a property to the market value or sale price of the property initial capital invested. It shows the percentage of the net operating income earned against the investment’s value.
The lower the cap rate, the lower the return. This could be optimised by simply adjusting lease terms, such as increasing rental rates, which translates to lower risk. Generally, core assets in high demand cities such as New York and London typically fetch a low cap rate.
2. Internal rate of return (IRR)
Internal rate of return is a useful metric for long term investment. As IRR takes into consideration the time value of money, by setting the net present value (NPV) to zero and estimating the duration of holding the investment, an investor can accurately calculate the profitability of any real estate asset. IRR in the core real estate market typically ranges from 10% to-15%.
3. Cash yield
Similar to IRR, cash yield is a useful metric for long term investments. The cash yield calculates the return on investment by taking the property’s annual net cash flow and dividing it by the investment’s down payment. Using this metric, the investor can calculate the profitability of a real estate asset relatively accurately.
The core investment strategy is beneficial for conservative investors who wish to mitigate risks in their portfolios. Whilst core assets generate comparatively lower returns than core plus assets, value-add or opportunistic investment strategies, they provide a predictable and stable income that is likely to remain so, even in the long run. Core investment strategy is excellent for investors who focus solely on earning passive income and can be a reliable investment option for investors to diversify part of their investments.
There are always upsides and downsides to every investment strategy. Investors must understand the strengths and weaknesses of different investment strategies to ascertain the one that best fits their investment objectives. Core real estate investment strategies may provide limited control, with a high entry barrier for investors, but tend to be hassle free, relatively stable and highly liquid. When coupled with the right metrics, investors would be able to accurately gauge the performance of their assets’ financial projections and make the right investment decisions.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.