Risk & Return: Understanding Property Classifications
Risk vs Return – Different Property Classifications
The RealtyShares marketplace lists investments with different risk / return profiles, and the relationship between risk and return is very important for investors to understand. We’ve earlier written about the difference of remedies across different financing types. Here, we’d like to focus on different property classifications, and how those may also affect an investment’s risk / return profile.
The value-add strategy generally pursued by many sponsoring real estate companies (“sponsors”) whose projects are listed on the RealtyShares marketplace generally involves greater risk than “core” or “core-plus” approaches, notably by an increased reliance on greater leverage, renovation or development, and a focus on secondary markets. Many listings also often involve what are referred to as “Class B” properties. These opportunities can feature relatively high return objectives. It’s important to note, however, that higher-quality assets (with lower return objectives) typically are associated with lower risk – a feature that many investors appreciate. Asset diversification plays a role in the investment objectives of many investors, and a mix of real estate investments involving properties at different points along the risk / return spectrum may be a desirable strategy for those investors.
The Overall Risk Spectrum
Most private real estate investments can be grouped into one of four broad categories that are distinguished by the degree of potential risk and return applicable to the property:
Core: Generally considered to be a lower-risk/lower-return strategy, this approach uses relatively low leverage and focuses on stable, fully leased, multi-tenant properties within strong, diversified market areas. The properties generally do not require significant improvements or renovations.
Core Plus: This approach also focuses on core-like properties, but with an increased opportunity for improving the property’s net operating income through modest measures such as rent increases upon lease rollovers or by modest property improvements. This is generally considered to be a moderate-risk/moderate-return strategy.
Value-Add: This approach is considered a medium to high-risk strategy which generally involves making relatively significant property improvements so that the market will assign a higher value to the property. Properties are considered candidates for a value-add strategy when they exhibit management or operational problems, require physical improvement or suffer from capital constraints. This approach may offer medium to high return objectives.
Opportunistic: This is considered to be a high-risk/high-return strategy involving development properties, the redeployment of markedly underutilized properties or other extensive enhancements.
Investments listed on the RealtyShares marketplace generally focus on value-add opportunities in middle-market commercial properties where a sponsor sees an opportunity to reposition the property to a higher and better use. The value-add opportunities at each project will vary, but generally will involve property upgrades or operational improvements that require only limited or moderate renovations, repositioning, re-tenanting or redevelopment at the project that real estate company believes should increase net operating income at, and result in appreciation of, the project. Projects with more extensive development plans will likely feature less current cash flow and more appreciation potential.
What are Class A, Class B, and Class C properties?
Properties may also be described as “Class A,” “Class B” and “Class C.” These property classifications are sometimes used to designate a different level of risk and return for a property, and thus may also factor into an investor’s return objectives.
These classifications tend to reflect a “grade” of a property’s physical characteristics, and sometimes of its location. The grades consider the age, location, and amenities of the property; its rental income and appreciation prospects; and its likely tenant income levels. There is no precise formula by which properties are placed into classes, but the breakdown is generally as follows:
Class A: These properties are generally newer properties built within the last 15 years with top amenities, high-income earning tenants, and low vacancy rates. Class A buildings are well located in a market and are typically professionally managed. They typically demand relatively high rents and have very few deferred maintenance issues.
Class B: These properties are generally older, tend to have lower income tenants and may or may not be professionally managed. Rental income is typically lower than Class A, and the properties may have some deferred maintenance issues. Generally, however, these buildings remain relatively well maintained. These are often properties that sponsors seeking “value-add” opportunities will tend to chase because through renovation and common area improvements the property can often be repositioned to be marketed at higher rental rates. Buyers are generally able to acquire these properties at higher cap rates (i.e., lower purchase price relative to net operating income) than for Class A properties, because Class B properties are viewed as somewhat riskier prospects.
Class C: Class C properties are typically more than 20 years old and located in less than desirable locations. The properties are generally in need of renovation, including updates of a building’s infrastructure, and tend to have lower rental rates compared to other local properties. Some Class C properties need significant redevelopment work before they can be expected to provide steady cash flows.
What Do These Categories Mean for Investors?
Property classifications tend to represent different levels of risk and reward. “Core,” Class A properties tend to be “top tier” properties that are often at less risk in times of a recession (unless high-income renters suffer disproportionately from that economic downswing). Foreign and institutional investors often prefer these properties because they are viewed as relatively low risk real estate investments. Class B and C properties, though, tend to be available at lower relative prices (since investors demand to be paid for the additional risk), and may present interesting opportunities — since significant property improvements or improved management can sometimes cause those properties to be re-positioned to higher operating incomes and valuations.
Return objectives thus tend to reflect the associated risk of a project. Higher return objectives signal higher risk; lower return objectives tend to be associated with lower risk. Class A “core” and “core-plus” properties may be an appropriate investment for investors seeking a degree of capital preservation, or for those simply seeking to diversify into less risky projects. Class B and C “value add” or “opportunistic” projects, however, may be more suited for investors seeking higher returns and capital appreciation. Investors should carefully consider their own investment objectives when assessing the gamut of real estate opportunities that are available. Remember, too, that real estate investments have many risk factors, so it is important to review the full offering materials for any investment that is being evaluated.