As real estate crowdfunding continues to grow, there will be more and more properties from which to choose. In the commercial arena, defined here as everything except single-family residential, how do you decide which properties to buy? One way to screen offerings is by strategy.
Risk and return are positively related. Moving up the return line requires moving to the right on the risk line, and vice versa. For example, if you don’t want to take a lot of risk, you can employ a Core strategy, but that means you must accept a relatively low return. To get a significantly higher return, as in Value Added, you have to take correspondingly higher risk
What are the strategies?
The four basic strategies are: Core, Core Plus, Value Added, and Opportunistic. These fall along a risk-return spectrum as follows:
Core: This strategy involves buying and holding well-located, well maintained properties that are fully occupied by creditworthy tenants. These attributes, along with typically low leverage, spell low risk. Cap rates (i.e., unleveraged yields) are currently low relative to the cost of money, with spreads in the 1% range.
Core Plus: This is also a buy and hold strategy. Risk is moderate, and cap rates are in the 6-8% range today. Leverage is typically moderate, up to 50% or so. If Core is highly polished silver, Core Plus is slightly tarnished. A Core Plus property may have a little vacancy; credit ratings of some tenants may be less than stellar; or the cosmetics may need some touching up.
Value Added: This involves a significant operational element in which the landlord makes capital improvements (renovation with or without expansion), leases up a fair amount of vacant space, and/or recapitalizes. The objective may be to sell for a profit or to hold and enjoy higher cash flow. Risk is moderate to high, depending on the nature of the project. Holding period returns (going-in cap rates don’t really count) on an unleveraged basis are in the 8-10% range, with leveraged returns in the teens.
Opportunistic: This strategy seeks maximum capital appreciation from land development, building development, major renovation or expansion, or distressed property turnarounds. Unlike the other strategies, which generate current rental income, opportunistic strategies entail an extended construction period in which there is no income, followed by a lease-up period (or in the case of land or condominium development, a sales period). So far the crowdfunding industry hasn’t embraced this strategy, but to the extent that Opportunistic projects can be found on a crowdfunding platform, it is advisable to limit the dollar commitment because of the risk. The dispersion of returns is extremely high, from a complete loss of investment to positive annual returns of 20% to 40%. Be careful with real estate in a pension plan.
Selecting the Right Strategy
Whether a particular property fits a definition exactly isn’t important. For example, there’s overlap between Core Plus and Value Added. What matters is your understanding of the physical and economic aspects of the investment, your rate of return objective, and your risk tolerance.
In private real estate, return is measured by the annual Internal Rate of Return, or IRR. Space doesn’t permit a detailed explanation of how the IRR is calculated, but the key points are that the return is compound, it measures total return (income + price change), and it’s sensitive to holding period, with the shorter the period the higher the return.
Income taxes dilute returns, so it’s important to understand the tax implications of the four strategies. Roughly speaking, the further down and to the left on the risk-return chart, the less the tax efficiency; i.e., the greater the proportion of the return that goes to taxes. While crowdfunding firms can’t give tax advice, they should be able to tell you whether more of the return on a particular investment is likely to come from tax sheltered cash flow, taxed as ordinary income, or capital appreciation, which is taxed at lower long term capital gains rates (assuming a holding period of more than one year).
Tell Me More About Risk
How about the risk side of the equation? In the liquid securities markets, risk is usually measured by the volatility of returns. In private real estate, where lack of liquidity keeps prices from being posted every day, risk measurement is more subjective.
The 2012 JOBS Act eliminated some of the burdensome requirements of private offerings. In particular, a Private Placement Memorandum does not have to be provided to the investor. That document, used by traditional real estate syndicators, contains a Risk Factors section. Without such a document to refer to, investors should ask the crowdfunding firm and deal sponsors for explicit feedback on risk.
Depending on your expertise, objectives, and risk tolerance, you may choose to concentrate in one of the strategies or diversify across strategies. In the latter case, you can allocate dollars among the strategies so as to move the portfolio in a direction along the risk-return line. For example, a risk tolerant investor, instead of investing equal amounts in each of the four strategies, might invest nothing in Core, 25% in Core Plus, 65% in Value Added, and 10% in Opportunistic. In contrast, a risk averse investor might put half the available dollars in Core and half in Core Plus.
Final Thoughts
In summary, investors can screen properties not only by property type and geography but also by sponsor strategy. Virtually all the information needed to make decisions is included on crowdfunding websites, but investors may want to go beyond posted data and talk to crowdfunding firms and sponsors, especially about risk factors.