Diversification is a foundational principle of nearly all risk management programs. One way to diversify a real estate investment portfolio is to deploy capital into assets at multiple points on the risk/return spectrum to protect it from extreme changes in the value of any one asset. It is a time tested strategy that can be applied to all property types.
When evaluating potential investments, we tend to place them in one of four buckets that categorize risk based on a property’s location, debt load, condition, occupancy, and return potential. Here is what investors should know about each.
A foundational investment is the bedrock on which an entire portfolio is constructed. By definition, they are the most stable and least risky assets. Their returns are lower, but they tend to be less volatile and and more reliable through all phases of the economic cycle.
Foundational investments are located in primary or secondary markets with high traffic and strong growth. They have low leverage, typically 50% – 60%, are in good condition with little deferred maintenance or major repairs needed, and have strong occupancy with good tenants. Because of their relative safety, returns for foundational investments tend to be lower, typically in the 4% – 8% range, and the majority of returns come from income with little chance for price appreciation.
Examples of foundational investments include triple-net leased properties with credit tenants, class A multifamily properties with full or near full occupancy, or office buildings located in the central business district of a major metropolitan area.
Foundation Plus Investments
In terms of risk/reward, Foundation Plus investments are the next step up from Foundational Investments. They carry slightly more risk, but offer the chance for slightly more return in the form of income plus growth.
Foundation Plus investments tend to be located in good – not great – locations with higher leverage, 55% – 65%, and some minor deferred maintenance. Foundation Plus properties are mostly occupied, but may have leases coming up for renewal that expose the property to some level of risk associated with renewal rates. Annual returns are in the 8% – 12% range and they consist of income plus some growth.
Examples of Foundation Plus investments include Class B multifamily properties in a secondary location or a 15 year old office building where some tenant leases are up for renewal and/or some minor cosmetic repairs need to be performed.
Moving to the next step up on the risk/return spectrum, Value investments are riskier assets that offer the potential for a higher return as an incentive to pursue them.
Value investments are in marginal locations with medium to high leverage, often nearing 75%. Value properties may have a high level of vacancy and/or a significant number of deferred maintenance items and cash flow may be highly variable due to the nature of the tenant base and rent roll. Real estate investors with a high degree of operational expertise may find significant “value” in these types of investments because they can apply their knowledge and leverage their networks to make necessary repairs and stabilize the property through new leases. Those that find success may also find great reward as returns for Value investments can range from 13% – 20% annually. Value investment returns are more heavily weighted toward price appreciation than income.
A good example of a Value Investment is a retail shopping center that has fallen out of favor with local residents due to a stale tenant base and/or physical deterioration. Those with the requisite expertise and retail connections could purchase the property, renovate it, and lease it to new, more attractive tenants.
Speculative investments offer a classic boom/bust scenario. This the riskiest bucket, but it also offers the greatest potential for return.
Speculative investments are those that may be in inferior locations, properties that have significant structural, occupancy, and/or management issues, or ground up developments that require significant up front investment. Speculative Investments may carry high levels of debt that can approach 80% – 85%, but the debt is highly dependent on the operator’s ability to obtain it. Conversely, the returns on speculative investments can be alluring for those willing to accept the risk. They can exceed 20% annually and are composed primarily of growth with little to no income for some time.
Examples of Speculative Investments include ground up development projects or the major renovation/reposition of an asset. In both cases, an operator would invest significant sums upfront with no expectation for a return until the project/renovation is complete, stabilized, and cash flowing.
For investors considering a real estate investment, whether on their own or through a private equity firm, it is important to know the difference between each bucket to determine if it is suitable for their risk tolerance and/or time horizon. Risk averse investors would likely prefer a Foundational or Foundation Plus investment for their reliable income and relatively lower risk for loss of principal. At the other end of the spectrum, investors with a high risk tolerance and/or long time horizon may prefer a Value or Speculative investment for their high return potential. No matter the preference, there’s a risk profile for everyone. The key is to find the right fit, to develop a business plan commensurate with the risk, and to execute against it to maximize return.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
We carefully consider the composition of the Capital Stack for every deal that we invest in and make sure that the interest of our investors is protected. Whether you’re just getting started as an investor or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.