COMMERCIAL INVESTMENTS…Risk & Return, Part 2

by Patten Mills | 3 min. read

All real estate investment strategies share a common goal of achieving a return above interest and inflation. The timing and the potential of their return depends on the type of investment property and strategy used. Categorizing commercial real estate into a spectrum of four general types of investments provides investors with perspective in evaluating which opportunities to pursue. Value-add and opportunistic properties represent the moderate to high-risk end of the continuum of commercial investments. Depending on the experience, skillset, and resources of the investor, these properties may be worth the risk for the chance of greater financial gain in comparison to their core and core plus counterparts.

VALUE-ADD PROPERTIES: Properties with Potential
Investors must determine the potential return that makes a project worthwhile. The higher risk associated with value-add properties relative to core plus equates to greater upside potential. Value-add investors can realize significant returns from appreciation as well as cash flow but must invest additional time and capital to achieve it. While core and core plus properties both, typically, have low vacancy and immediate cash flow upon acquisition, value-add properties have limited or reduced cash flow before the value has been added and, therefore, much less predictable returns. The property may have anything from below market rents, low occupancy, significant deferred maintenance, or require major renovations. An investor must have the skillset, resources, and experience to either decrease expenses or increase income.

For example, construction companies interested in owning or flipping commercial real estate are an example of an investor who may be well equipped to take on a value-add property in need of major repairs. They would have the knowledge, resources, and expertise to renovate the property as well as estimate the cost and timeline of the project. If a construction company can purchase and renovate a property in the right location, they may have the potential to attract stronger tenants and reposition it to a core or core plus asset. This would allow the property to obtain higher rents and sell at a much lower cap rate. Similarly, an engineering company may recognize the potential developability of a piece of land and find it financially worthwhile to purchase it and then sell to a developer with entitlements in place. In both scenarios, the investors have the right skillsets to add value.

OPPORTUNISTIC PROPERTIES: The Big Swing
Examples of Opportunistic investments include functionally obsolete buildings that require redevelopment and land development. For example, sometimes land is more valuable than the building on it. Opportunistic investments are associated with the highest risk and potential return of the four classifications. Returns are even less predictable than value-add properties. These investments often may not see a positive return for three or more years but, typically, have the potential to achieve the highest return of these investment categories in terms of both cash flow and appreciation.

Opportunistic investment can be seen locally in Red Lion Borough in the repurposing of the three-story functionally obsolete industrial building located at 252 North Franklin Street. The developer purchased the property in late 2020 after receiving approvals to convert it to a 96-unit apartment building with a microbrewery and coffee shop as additional tenants. The first phase of the Red Lion Table Company apartments opened this summer and were preleased. The commercial space will be occupied by Grounding Specialty Coffee and Black Cap Brewing Company.

Financing is a major variable in feasibility of opportunistic investments and can be for value-add properties also. Financial institutions are less likely to lend based on pro-forma returns for a project so far away from completion. Experience in similar projects is beneficial, or even required, to receive construction loans. Financing terms may not allow vacancy to drop below a certain percentage or require a cash position, adding default to the risk. Building a portfolio of smaller projects and working up to larger deals is one path to growth for an opportunistic or value-add investor. For instance, taking a functionally obsolete multi-family apartment building and renovating the layout to convert dead space to additional units could be the starting block to repurposing vacant warehouse or office buildings to residential apartment complexes in the future. Acquiring other core plus or core real estate assets is another way of strengthening a real estate portfolio to support a riskier investment.

Part 1 of this blog examines core and core plus properties in further detail.