Advisors are increasingly discovering the potential benefits of private real estate: tax-favored income, potential appreciation, low volatility, and uncorrelated returns. Private real estate may enhance a traditional balanced portfolio's risk/return profile. But which style should an advisor use in client portfolios?
Practitioners classify private real estate across the risk spectrum by strategy type which are typically categorized in two groups, Core and Non-Core.
Core Investment Strategies generally focus on acquiring and owning assets with dependable income streams and relatively stable value and often involve lower leverage. The “Core” and “Core-Plus” strategies in this category are often viewed as fixed income alternatives.
Non-Core Investment Strategies generally focus on value-creation activities with the intent of producing higher total returns than are typically available in Core investments. The “Value-Add” and “Opportunistic” strategies in the Non-Core category are frequently considered as investment strategies akin to equities.
Selecting the right private real estate strategy is like choosing the right investment style for a stock or bond allocation. Advisors select a strategy or style for how it can help meet a client's objectives or contributes to a portfolio's risk/return profile. Depending on the investor's needs, an advisor can tailor a portfolio that best fits a client's return objectives and risk tolerance.
For example:
- An income-oriented retirement investor may prefer the higher yield and lower risk of core real estate.
- A younger investor with a higher degree of risk tolerance, a long time horizon, and a preference for growth could explore a value-add or opportunistic strategy.
- An institutional investor may use a "core and satellite" approach: core real estate as the foundation of the institution's private real estate allocation, with satellite allocations to value-add and opportunistic strategies.
Core
Core serves a role similar to traditional fixed-income investments. Core real estate can offer income and attractive risk-adjusted returns for investors with longer time horizons. Core properties are generally high quality and fully stabilized with low leverage and long tenant leases. Trophy properties in central business districts of major cities are typical core properties and are less sensitive to market and economic volatility than higher-risk strategies.
Core-Plus
Core-plus is also considered a strategy similar to fixed income investments but may have a greater potential for capital appreciation than “core” described above. Quality properties with minor upgrade requirements (such properties may be older) are the hallmark of core-plus real estate. Prudent leverage can enhance returns with a controlled increase in risk. Property owners will attempt to increase cash flows through minor improvements, increasing tenant quality, restructuring lease rollover schedules, or improving management efficiencies. Core-plus properties produce steady cash flows, but some cash flow may be used for deferred or future maintenance to upgrade buildings, parking, or amenities.
Value-Add
A Value-add strategy is akin to an equity manager's approach in investing in stocks they believe are undervalued or trading below intrinsic value. Improving or redeveloping property to enhance its use and value is key to value-add. To reach full value, assets in this category need help. Problems to solve include deferred maintenance, below-market occupancy or lease rates, or sub-standard facilities needing significant improvement. Corrective action may consist of renovations, management restructuring, enhanced marketing, sales, etc. Value-add managers will use higher leverage levels to drive returns, pushing the strategy further out the risk spectrum from core and core-plus.
Opportunistic
Opportunistic real estate is comparable to an aggressive growth strategy in the equity markets. While opportunistic real estate offers the least predictable cash flows, the strategy provides the potential for the highest returns. The focus is on ground-up development, rehabilitation, and distressed properties and loans. Typically, opportunistic strategies will pursue assets with limited or no current rental income. A large portion of returns will come from capital appreciation upon a sale. Opportunistic properties will generally use significant leverage to magnify returns. Opportunistic is the most aggressive and risky of the private real estate strategies.
Conclusion
Which style of private real estate is right for you and your clients? The style that matches the needs of each particular client. The flexibility and diversity of private equity real estate mean solutions can be found and readily matched to the risk/return profiles of your client's traditional stock and bond allocations.