Understanding Expected Returns Vs Risk in Commercial Real Estate
When investing in commercial real estate, it’s important to understand each investment type and average return on investment (ROI) before deploying your capital. Whether you’re purchasing retail, office, industrial, or multi-family, determining which investment class best represents you, will establish your risk tolerance and help find the right investment that aligns with your goals. We have found that astute investors typically spend a great amount of time planning with a trusted real estate advisor to educate themselves on current market conditions and expected risk/returns before making their initial investment.
When measuring investments and their offered return, we look at the following characteristics: location, CAP rate (CAP rate = net income ÷ purchase price), income growth over a hold period, strength of tenant(s), length of lease term, and management intensity. Understanding these different attributes will help investors determine the amount of risk each investment offers and provide them with the ability to identify which properties are overvalued, undervalued, or in line with market pricing.
Below are examples of five investment classes which are commonly used by investors and real estate professionals to classify commercial real estate investments:
Risk-Free (Non-Real Estate)
Risk-free investments are non-real estate investments, such as Bonds, CDs (Certified Deposits), Money Market Accounts, Savings Accounts, Treasuries, and Notes. These are considered risk free investments because of their fixed returns and high liquidity. Due to their safe nature, these investments run the lowest on the return spectrum compared to all other commercial investments. Understanding risk-free investments in commercial real estate is important because it provides a baseline for all other investment classes below and can shape the market.
Core investments are arguably the most sought-after properties in commercial real estate and can be single tenant or multi-tenant. These investments can be single or multi-tenant properties and often contain long-term leases backed by strong corporate tenants, such as Starbucks, In-N-Out, and Walgreens, to name a few. If single tenant, the average remaining lease term is around 10 years while multi-tenant is a blend of 5-10 years remaining. There is little to no management on these properties and the strategy for most investors when purchasing is a long-term hold plan. From a risk perspective, these investments offer the lowest amount of risk as well as return.
Core plus investments can be either single or multi-tenant and offer investors an increase in return and risk compared to core investments. These properties can include as few as one tenant to greater than twenty. With an increased number of tenants and higher returns, owners can be faced with shorter leases, which give a higher chance of vacancy and constant lease negotiations/renewals over an ownership period. These properties usually consist of smaller tenants rather than national tenants. The increased day-to-day involvement from the owner and higher risk of vacancies are why returns on these investments are higher than core assets.
Value add investments are some of the highest risk properties in the market. These investments are the properties low risk investors tend to avoid and usually contain some sort of issue that needs to be solved. Whether it be a high amount of vacancy, deferred maintenance, short leases, or larger vacancies not in demand (think vacant K-Marts and Drug Stores), these investments are attractive to investors because they see an opportunity to add value and increase the return. Value-add buyers are considered full time investors and are very hands-on in the day-to-day of these properties.
Opportunistic investments, often done by the most sophisticated investors, offer the highest risk and, if done successfully, can award owners with very high returns. Examples of opportunistic properties are empty buildings or shopping centers, raw land to be developed, and teardowns with replacement at the highest and best use. Investors will view these investments with a long-term plan, unless doing a flip or something short term with high risk on the front end. Much can go wrong, and risk is very high due to a variety of assumptions and unknowns. Owners can be faced with the risk of a complete loss of initial investment.
What’s Your Risk Profile?
Understanding your risk profile and which investment class you fit into is the first step towards making the right acquisition for your current needs and goals. If you’re looking for a long-term investment that generates steady cash flow, then a core or core plus asset might be the right fit for you. If you’re one who thinks taking great risk is worth the reward, then value-add and opportunistic properties might be a better fit.
Consult with an Investment Professional
At the Visintainer Group, we carefully analyze each client’s situation, risk tolerance, and objectives to develop a custom strategy tailored for their needs. Whether it’s purchasing your first commercial investment or adding to your portfolio, our proven track record and market knowledge ensures that clients are investing in the property that best aligns with their objectives, not ours.
John Kourafas, CCIM, is a Commercial Investment Advisor with the Visintainer Group in Fresno, CA. Formed in 2018 and built on a foundation of investment real estate, the Visintainer Group is a client-first commercial real estate firm. The Group has executed over $550 million in transactions across the United States. John specializes in commercial property acquisitions and dispositions for owners in the Central Valley, Sacramento, and Central Coast markets. He can be reached at 559.890.0419 or [email protected].