The real estate landscape consists of 3 primary investment types with varying degrees of risk and return. They are as followed:
- Stabilized investments
- Value Add investments
- Opportunistic transactions
Stabilized properties are commercial assets that have at least the overall market occupancy or are 95% occupied. They are fully leased up and risk is really only inherent when a tenant lease is coming due and the need to renew or release the space is imminent. These properties are deemed the safest to investors versus value-add or opportunistic. They are fully leased at market rates. Examples include single tenant, triple net retail and 100% leased office buildings.
Value Add real estate investments usually involve cash flowing properties but aren’t fully leased and often need improvements and a repositioning within the market. These improvements could involve physical enhancements to the building, adding amenities, or just involve superior management. This will attract tenants to the property and/or increase rents. Value add investors often utilize higher leverage in the form of bridge or mezzanine financing to take the property from under-utilization to capacity. The returns can be very attractive but risk is also higher if the operator fails to meet the objectives as sought after in the business plan.
Opportunistic transactions are similar to value add investments but often involve significant rehabilitation or ground up development to realize their potential and fulfill the investment plan. Often times there is little to no occupancy and the building may be a shell from someone else’s poor use of leverage, think Sam Zell, a.k.a. the “Grave Dancer”. The plot may also be raw land which needs construction financing to even get a structure into place. This investment strategy is the highest risk but also yields the highest rewards. If executed successfully and for the right basis, the returns can be substantial. If executed poorly or with improper use of leverage, the developer may go bankrupt.
The type of strategy employed by an investor often is a function of their utility function. Investors seeking higher investments with a higher risk/return profile will often utilize opportunistic or value add investments with a large degree of rehabilitation needed for the project. Investors with a smaller appetite for risk often seek stabilized properties to offer a “coupon clipping”, bond-like investment.