The Real Estate Risk Spectrum: Considerations for Modern Investors
All investments involve risk. In a sense, return on investment is, by definition, compensation for risk taken. Passive online real estate investing (or “real estate crowdfunding”) is a relatively new asset class, but fundamentally exhibits the same set of risk factors as commercial real estate investments always have, which will vary from offering to offering and exhibit some consistent themes. Each platform in the nascent ‘real estate crowdfunding’ space presents risk factors differently, however, so it can be difficult at times for investors to efficiently and comprehensively understand the risk factors of a specific offering.
Understanding the specific risk factors in any investment is critical to effective investing, especially for investors who are newer to the passive commercial real estate investing space. This article breaks down some major themes in commercial real estate risk assessment – the big factors that institutional investors examine closely when evaluating deals – as well as other considerations for individual investors just getting started with this relatively-new mode of real estate investing.
The Classic Real Estate Risk Spectrum
Long before platforms like EQUITYMULTIPLE emerged to offer passive private commercial real estate investments, CRE investment firms had established a set of common nomenclature for classifying types of projects and their typical risk/return profile.
Project Type & Risk
Commercial real estate developers and investment firms typically segment project types into four buckets of investing strategy based on inherent risk and return potential. Let’s go over these categories, from lowest-risk/lowest-return potential to highest-risk/highest-return-potential:
Core Real Estate
This strategy typically means employing a relatively-low degree of leverage and pursuing stable, fully (or mostly) leased properties with a diverse tenant mix. The property itself will be in good shape, with little need for major renovations, and will be located in a demand-heavy Tier I or Tier II market with strong underlying fundamentals. In most cases this will be a “buy and hold” business plan, relying on predictable appreciation to deliver modest returns with relatively little attendant risk.
Foreign capital often pursues Core real estate investments in gateway U.S. cities due to perceived safety, such as the significant flow of investment from Chinese investors into stabilized multifamily assets in New York City in recent years. These investments also tend to hold up very well during economic downturns, as the assets are typically leased to reliable, creditworthy tenants and the property is typically located in a market with a strong and diverse enough set of demand drivers to fare relatively well during a slump.
While these investments entail a relatively low degree of risk, they typically project to IRR’s in the mid-teens, or lower.
These projects also focus on relatively-stable, newer assets in strong, established markets and submarkets, but also entail increased opportunity in the form of some property renovation and optimizations to rent roll. Typically at least one attribute of the underlying asset is riskier than you would expect from a core investment – the property may be in a suburb or secondary market, or the property may not be fully-leased (which presents both risk and opportunity).
Value add real estate projects entail a higher level of risk alongside greater potential for driving operating revenue growth and appreciation. Assets targeted by value-add Sponsors show some potential for performance growth – due to suboptimal management or operations at the property, opportunities for moderate renovations to attract higher-paying tenants, significantly higher prevailing rents in the immediate area, or some combination thereof. “Repositioning” is often synonymous with the value add real estate investing strategy: making selective improvements to an existing property before marketing it in a new way to a new profile of potential tenant.
In many cases value add real estate sponsors and developers will also look toward markets and submarkets with substantial (and often underrated) potential for NOI growth due to demographic trends and new demand drivers accretive to the property’s rental demand.
These higher-risk, higher-return projects often offer appealing potential returns for investors if they believe in the Sponsor’s investment thesis, and particularly if the Sponsor has executed on similar projects in the same area.
These projects often entail the longest hold period, the least in-place cash flow, less-established secondary or tertiary markets, or some combination thereof. However, there is often the potential for outsized returns if the Sponsor or developer is able to execute their business plan.
Properties requiring significant rehabilitation and with little to no in-place rent roll typically fall into this category; as do ground-up development projects. Such projects typically entail a business plan with many moving parts, a hold period of 3 or more years with no cash flow, or both, which can all amount to significant risk.
While opportunistic investments entail a relatively high degree of risk, they typically project to an IRR of 25% or more, and sometimes much higher*.
Commercial Real Estate Classes – Grading Properties
In a related but different convention, real estate investors will describe properties as “Class A”, “Class B” or “Class C”. Much like the categories of risk/return discussed in the previous section, these grades are fluid and somewhat subjective, but here is the general idea:
Class A Real Estate
Class A properties are assets that are relatively new (typically constructed within the past 10-15 years), offer a suite of attractive modern amenities, and command the highest rents in a given market or submarket within the asset class.
Since technology and the preferences of high-end tenants change over time, so too does the definition of “Class A amenities”. At present, a prospective tenant in a Class A multifamily property might expect in-unit, high-efficiency washer/dryer, a rooftop greenspace and gathering area, and an on-site fitness center with new equipment. A Class A office tenant may expect sustainable, modern design, an open floor plan, and locker/shower facilities.
Class B Real Estate
These properties are often simply Class A properties that have aged, with features that are antiquated by the standards of the current Class A stock. This includes historic assets that are well-maintained and have vintage charm, but nethertheless command lower rents by virtue of outdated features like single pane windows, pre-modern kitchen appliances, or lack of parking.
In some cases, new construction of Class B properties occurs to meet the demand from less affluent or well-capitalized tenants, with amenities and features that are perfectly serviceable but not cutting-edge. This is far more common outside urban cores, where high multifamily demand from affluent professionals (and, by extension, high-end office and retail tenants) prompts more Class A development.
A common business plan among value-add real estate sponsors is the rehabbing of historic assets: maintaining the legacy charms of the property while adding modern amenities, ancillary features like parking, energy efficiency upgrades, or some combination thereof.
Class C Real Estate
These properties are typically older, cheap to rent, and lacking in the design quality and amenities to make them desirable for most tenants. This encompasses multifamily properties that have fallen into disrepair, derelict malls, and industrial or office space that can no longer provide adequate space for the operations of modern tenants.
Value-add or opportunistic sponsors may drive value by converting Class C multifamily properties into Class B properties through better maintenance and management, and by significantly rehabbing the property so that it is safe and functional for residents. This type of project is often aimed at providing more workforce housing in growing suburbs and exurbs, particularly when amenities like transportation assistance and onsite daycare are included, and where sponsors can take advantage of local or national tax incentives.
The stock of deteriorating malls and obsolete warehouse space in the U.S. presents both challenge and opportunity for developers and legislators. Various concepts have been explored, including urban farms, vocational colleges and micro-apartments.
Real Estate Crowdfunding: New Opportunity, New Risk Considerations
Online investing platforms that allow for passive commercial real estate investment (at relatively-low minimums) afford investors the opportunity to access investments that span the real estate risk spectrum and Class A, B, and C properties.
Risk in the Unknown
Part of the appeal and downside protection in real estate investing is tangibility: real estate assets can be seen and felt, and provide inherent worth. Unless you are investing in your own city, you will inevitably lose the ability to tangibly evaluate an asset when you invest via an online real estate investing platform. Furthermore, when you co-invest alongside a real estate firm via an online platform, you typically won’t have the opportunity to meet the principals in person. Many investors are understandably leery of these ambiguities. Here are some ways to mitigate this “risk in the unknown” and get more comfortable with this mode of real estate investing:
- Get as much info as possible on the asset, market, and investment thesis. Wherever the investment lies on the risk spectrum (from core to opportunistic, Class A to Class C), be sure to understand the risk factors in detail. The opportunity should be brought to life in the platform’s presentation of the offering. If it isn’t, proceed with caution. In other words, these investments are much more than a return projection – be sure to understand how those return projections were arrived at.
- Get to know the real estate firm that you are considering co-investing with. Do they have a solid track record executing on similar projects? Do they have local, boots-on-the-ground experience? Again, if this isn’t apparent in the platform’s presentation of the offering, proceed cautiously.
- Get to know the platform. Be sure that there are real people willing to answer your questions, who conducted extensive diligence on any investments you consider.
Liquidity Risk, and Diversifying Across the Real Estate Risk Spectrum
With the new paradigm for commercial real estate investing, you can diversify across the risk spectrum and, similarly, across projected hold periods. You can supplement longer-dated value add or opportunistic equity investments with debt or preferred equity investments that offer more security and shorter holds, protecting yourself against liquidity risk and building more downside protection into your portfolio.
For more on how alternative assets like private commercial real estate can offer “alpha” and mitigate exposure to systematic risk, please refer to this article.
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