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Four Categories of Risk & Reward

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Four Categories of Risk & Reward

Core, Core Plus, Value Add and Opportunistic are standard terms to define strategies for investing in real estate based on the risk and return characteristics of an investment. These strategies have led to properties being classified according to which of these strategies they are likely to match. While these categories are mainly used in Commercial Real Estate, the principles apply equally to residential opportunities. 

One of the key aspects of the risk is the predictability and stability of your cash flow from rentals, now and in the future. The more uncertainty around cash flow, the higher the potential risk.  

Using this as a simplification for understanding the four strategies, here is a summary of the categories. 

Core: These properties are fully developed, operating at their maximum potential with little room for adding value through renovations, additions or change. They are in prime locations, with blue chip tenants and constantly fully leased. There is existing rental income that is very stable and predictable, and least likely to be affected in an economic downturn. The value of these properties is tied directly to the existing rental income, and as such any growth in the value only arises when there is a change in the underlying rental market. The returns on these properties is relatively low, as there is strong demand for these low risk investments, and people are prepared to pay higher prices. These properties are generally expensive and owned by larger REIT’s and funds. As the returns are relatively low, there is not a lot of room in the returns to make money after paying off any financing, so these properties usually are not heavily leveraged. 

Core Plus: This property category is similar to Core, though with one or two characteristics that may create a bit more risk or uncertainty around the cash flow. While there is relatively stable and predictable existing rental income, the property may be getting older, or it may be situated slightly further away from the prime metro locations. These aspects introduce an element of risk that the tenant base may be slightly more mobile or not of the same blue-chip quality. Given this increased risk, the price of these properties will be less than for a Core building. This leads to higher possible returns than the Core strategy, though with the additional risk. 

Value Add: As the name suggests, the value-add strategy involves finding properties with existing income from rentals, though where there is also an opportunity to add value to the investment through making changes to the property or tenant base. The changes could be renovating the buildings in order to achieve higher rentals or building new additions to the property. This class of property provides both regular incomes, as well as the possibility of increase future growth in the value through the improvements. However, with any value-add strategy there is increased risk as the changes may cost more than expected, or once the changes are made they do not lead to the expected increase in rental incomes or capital growth. 

Opportunistic: This property category has the highest risk for cash flow and income. Deals generally involve turnaround situations or new developments. There is inherent risk that projections for either the costs of the changes or developments, or the expected income from rentals or the sale of the property after the changes have been made, may be wrong. It often requires bold investors to step in with a high degree of expertise to ensure a successful turnaround.  

Over and above the factors mentioned above, there are many factors that influence risk, and each opportunity will have its own mix and story. The key drivers that lead to a property being categorised into one of the four categories do not capture the complete picture. The property type, Sponsor’s reputation and experience, location, market fundamentals, business plan, and degree of leverage of just some of the factors that an investor should consider. 

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