Investor tip: Are core assets worth the risk?

The four primary asset classes. Courtesy Northstar Commercial Partners

Brian Watson
Founder and CEO, Northstar Commercial Partners

Are you looking to make modest investment gains, play it safe or create wealth? All investments come with risk, but ideally the return is a direct reflection of the risk. I submit that core real estate investments, despite their perceived safety, present similar risk as other real estate asset classes – and maybe even more in the current investment cycle – but their modest returns do not reflect their risk.

In the world of commercial real estate investing there are a multitude of product types and asset classes, but for the newly initiated, there are four primary asset classes to consider.

• Core. There are nuances, but it is easiest to think of core assets as being Class A office buildings or trophy buildings usually located in core urban markets, with very low vacancy, high rents, low tenant turnover and national credit tenants. These often are considered the safest real estate assets to invest in because they typically are in good condition, easily marketable, in demand, have strong cash flow and provide steady distributions to investors. Core investors typically seek regular income distributions and expect a holding period of seven to 10 years and 5 to 11 percent annualized returns.

• Core-plus. Core-plus assets are very similar to core, except there may be opportunity to increase the value through modest additional investment or because it is purchased with more vacancy, which allows the new owners to fill the vacancy with new leases, ideally at higher rents. Core-plus investors typically are seeking regular income distributions and expect a holding period of seven to 10 years and 8 to 12 percent annualized returns.

•Value add. Think of value add as assets that may be past their prime, have poor management, high vacancy or their current use is not the highest and best use. This gives new owners the opportunity to invest in remodeling, put stronger management in place, sign new leases or reposition/ convert the asset to a different use. For example, repositioning or converting the asset could mean turning a single tenant office building into a multitenant office or turning a warehouse into a self-storage facility. Value-add investors typically do not expect much, if any, cash flow the first few years and only expect to hold the property for two to seven years and hopefully achieve 12 to 20 percent annualized returns.

• Opportunistic. The most common way to think of opportunistic properties are new construction or assets that are highly distressed, in foreclosure, have financial or ownership issues, or are in challenging locations. Except for new construction, the investment strategy for opportunistic is very similar to value add. With new construction, investors get the chance for significant returns because they are creating the income from scratch. These typically are considered higher risk, speculative investments and use leverage, but often the risk can be mitigated with preconstruction sales and leases. Opportunistic investors do not expect cash flow and recognize a majority of their return will come from the back-end sale of the property. They only expect to hold the investment for one to five years and seek 18 percent or more annualized returns.

We have provided institutional and self-directed accredited investors with annualized returns of over 43 percent over the last 17 years and that is largely due to staying away from core asset investments while staying true to a disciplined and methodical investment strategy.

If you think about it, there are only two things that can happen with core assets: They can chug along and barely beat actual inflation, or they can fail to keep pace with inflation. Core assets do not have many options to remain competitive in a changing market without reducing the return to investors. If things go awry, such as increased competition from new buildings coming on the market, then there is an increased chance the national credit tenants will jump to the newer, shinier property. The only option for the landlord is to provide rental incentives to keep them, meaning lower rents, free rent or dollars to improve the tenant’s space. When a tenant does vacate, it is likely the landlord who will forego rent for a short period and also has to spend money for leasing commissions and possibly redesigning and/or refurbishing the space. The landlord probably already was charging the highest rent the market could support, so with each turnover the property’s investment performance suffers.

If you are looking for relative safety and modest income, then a core asset may be a good decision; but if you are looking for growth or income beyond just trying to stay ahead of inflation, then you may want to consider the other asset classes defined above.

Featured in CREJ’s September 2018 Office Properties Quarterly

Edited by the Colorado Real Estate Journal staff.