COMMERCIAL INVESTMENTS…Risk & Return, Part 1

by Patten Mills | 3 min. read

Investment properties look substantially different to someone who intends to be a passive investor and realize an immediate cash flow compared to the risk-taker with a vision who is willing to make a gamble in hopes of high returns. Factors used to measure risk such as the property’s physical condition, location, occupancy level, tenant creditworthiness, length of leases, and financing plan play important roles in the evaluation of risk-verses-reward. Core, core plus, value-add, and opportunistic investment properties are ways of categorizing commercial real estate assets on a scale of volatility of return, with core and core plus properties generally representing the low and low to moderate risk end of the continuum.

CORE PROPERTIES: Slimmer Returns for Safer Investments
Any type of investment real estate from office and industrial to retail, mixed-use, and multifamily can be categorized within the spectrum of core to opportunistic. In a range of conservative to aggressive, core properties are considered the safest real estate investments. Core properties can be an alternative to bonds for conservative investors. Their relative lack of volatility and resilience during economic downturns can also help offset riskier ventures in a diverse real estate portfolio. Typically characterized by creditworthy tenants with long term leases and little to no vacancy, these properties are usually in prime locations and well-maintained with negligible deferred maintenance or owner responsibility. The low risk of core properties relative to the other categories of investment properties results in lower cap rates, a metric that reflects the risk and return of an investment property and inversely impacts the price. Single tenant net lease and turnkey multifamily properties are two examples of real estate investments that can be considered core properties, and both trade at relatively low cap rates.

Single tenant net lease properties are known to sell at the lowest cap rates of investment real estate because these lease structures leave minimal maintenance responsibility on the owner and tend to have longer term leases, making them desirable as a passive income stream. Similar to government bonds that are considered one of the safest investments because they have the backing of the full faith and credit of the U.S. government, single tenant net leases are often guaranteed by the full faith and credit of the corporation behind the occupant. Cap rates within this product type vary based on creditworthiness of the tenant. For instance, real estate leased to CVS is known to trade at a lower cap rate than Rite Aid. In July 2021, Fitch Ratings discussed Rite Aid’s credit rating compared to its peers and provides insight into why that is, such as the corporation’s Long-Term Issuer Default Rating of B-, minimal to negative cash flow, and significantly higher leverage profile than competitors.¹ According to CoStar analytics, the average cap rate of Rite Aid investment sales within the past two years was 7.7%. Meanwhile, the average cap rate for CVS was 5.7%.² While cap rates vary depending on market conditions, the difference in these averages provides insight into the differing strengths of these tenants, which results in varying levels of risk even within the core property category.

While multifamily properties leave much more maintenance responsibility to the owner, residential investment is inherently safer than commercial given that housing can be viewed as a commodity. Multifamily properties with management in place that are well located, well maintained, and have high occupancy could also be considered core properties and provide a passive income stream like single tenant net leases. The average cap rate for multifamily properties sold in PA within the past two years was 7.6% based on CoStar data.³

Given that these properties are already stabilized upon acquisition, the return from core properties primarily derived from cash flow rather than appreciation. The low risk of single tenant net lease and multifamily properties keeps cap rates low and, therefore, the margin of return slim. The financing terms a particular investor can obtain might determine whether an investment makes sense. Too high of an interest rate could reduce profit, perhaps making it more logical to allocate the capital elsewhere, such as in stocks or bonds. On the other hand, low interest rates and depreciation could result in returns significantly higher than securities would yield.

CORE-PLUS PROPERTIES: Higher Returns for the Headache of Management
Core plus properties can be an alternative for investors who desire a higher return than core properties can provide and are willing to take on a little more risk and management to achieve it. Core plus properties are often multitenant buildings. One advantage of multitenant properties is tenant diversity because all the property’s income is not tied to one tenant. The downside is the headaches of management. Core plus properties generally have strong tenants, low vacancies, and are cash flowing but require more involvement from ownership and locations might be secondary. They are considered to have low to moderate associated risk and less predictable returns than core properties. In accordance, core plus properties are expected to have higher cap rates while still being relatively safe investments. In addition to cashflow, some value can come from appreciation if the return can be increased.

Factors hurting cashflow might include some deferred maintenance, management deficiencies, or below-market rents. The buyer of a core plus property must be able to identify necessary improvements and understand their costs to evaluate potential return. In multitenant buildings such as shopping centers or office complexes where the owner is often responsible for roof and structural components, implementing professional property management can be a solution to handling maintenance issues and budgeting for repairs to increase returns. Knowledge of different commercial lease structures might even allow an investor to spot an opportunity to implement property management and bill the costs back to the tenants, turning it into a more passive investment. In the case of below-market rents, the buyer must be prepared to negotiate rent increases and potentially lose tenants to do so. With improvements to the spaces, it may not only be possible to acquire new tenants but reposition the property to attract stronger tenants willing to pay higher rents. An experienced brokerage advisory team can help provide a strategy for negotiations and filling potential vacancies.

Each type of investment property has different benefits and drawbacks. Viewing properties in terms of appetite for risk, potential return, ability to obtain financing, and experience needed are crucial in finding investments that align with the desired goals, skillset, and strategy of the prospective buyer.

Part 2 of this blog will cover the riskier end of the real estate investment spectrum: value-add and opportunistic properties.

Sources

¹ Fitch Ratings – https://www.fitchratings.com/research/corporate-finance/fitch-affirms-rite-aid-corporation-at-b-outlook-revised-to-negative-28-07-2021
² CoStar Analytics Report – Sales after 4/25/20 in PA with Rite Aid and Walgreens as tenants
³ CoStar Analytics Report – Multifamily Property Sales in PA after 4/25/2020