Understanding the Risk Return Curve of Real Estate
Post by Benjamin Lapidus, Director of Acquisitions, Spartan Investment Group, LLC
The risk return curve highlights the relationship between the return of an investment in real estate and its relative level of risk.
Risk is a measure of volatility, a margin of error. For example, you could have a 4% return + or – 1%, which is both low risk and low return. Or you could have a 25% return + or – 50%, which is both high return and high risk.
To create a standard, the industry categorized real estate equity investments into four risk-return buckets:
1) Core Assets: These assets are the McDonald’s stock of real estate, exhibiting slow, incremental gains with very low volatility in value. And REITs focusing on core assets are the S&P 500 Index of real estate. Core assets are stabilized assets in core markets. For example, a 100-unit apartment building in the heart of Denver, CO that is 90% occupied at market rents.
Target Return Range: 2-8%
2) Core Plus Assets: These assets perform a lot like Core Assets, but there is a particular feature about them that makes them not as low risk. For example if we take the same exact facility described in Core Asset and airlift it to Forney, TX which is part of the Dallas, TX MSA, but is not in Dallas itself, it may be considered a Core Plus asset. Forney, TX is considered a riskier location than Dallas, TX.
Target Return Range: 8-12%
3) Value Add Assets: These are assets where additional value can be created either as a result of increasing revenue on the existing business, decreasing expenses, updating amenities, aesthetics, or major systems, changing lease terms, or other creative mechanisms.
Target Return Range: 12-19%
4) Opportunistic: These deals range from raw land to horizontal development, vertical construction to major expansions. In most cases, there is not a history of cash flows, and the developer is speculating that there will be value in the executed business plan. There are many more barriers to success, which is higher risk, but often times the reward far outweighs the measurable risk.
Target Return Range: 20+%
This is not a one-size fits all chart. You may see value add opportunities on 100-unit apartment buildings in the heart of Denver, CO. You may see development opportunities in midtown Manhattan where the city is guaranteeing cash flows on affordable housing. And there are also thousands of ways to mitigate risk, so that even if you are high up on the risk-return curve, the right investor can generate Opportunistic returns with Core Plus level risk. There’s also hundreds of ways to be operationally ignorant, so that a Core asset becomes dilapidated and a cheaper value-add asset for the next investor. And regardless, of the asset type, you can always make the mistake of overpaying or find a great, underpriced deal, which will affect the ultimate return to investors.