Mutual funds and bonds are at one end of the spectrum that, with high liquidity and low risk, deliver commensurately low returns. Stocks can have higher returns but are naturally volatile and susceptible to market fluctuations driven by market sentiment.
Commercial real estate, in a way, offers the best of both worlds with a strong return profile as well as relative stability. Many look to real estate investment to bring balance to their portfolios, but there’s a right and wrong way to do it. Here’s the right way.
The Different Types of Real Estate Investing
When high net-worth investors are looking for commercial real estate to diversify their portfolios, they understand that not all properties are created equally. Location plays a big part in this, and one of the easiest ways to break this down is through primary markets (major cities like New York, Los Angeles, Chicago, and their respective metropolitan areas), secondary markets (for example, Portland, Seattle, Salt Lake City), and tertiary markets (smaller, lesser known areas).
The larger the market, the higher the cost of entry, but also the greater the stability brought about by sheer weight of demand in those population dense, economically active areas. For larger returns on investment, seeking higher cap rate properties in secondary markets has proven a predictable formula for increasing returns while mitigating risk. This is the classic ‘value investing’ model applied to real estate, where an asset that is undervalued for some reason, but nevertheless holds sound fundamentals, can outperform the more glamorous options in higher priced locations.
Different asset classes within real estate also present a range of options to the investor looking for diversification. Industrial warehouses, for example, are generally located in tertiary or secondary locations and, often only house a few large tenants. As a result, they present an entirely different risk-return profile to, say, multi-family residential investments where the vacancy of a single tenant poses only minimal impact on cash flow.
Broadening the asset class profile further, there are four different investment strategies for commercial real estate that are related to geography and real estate type. These are core, core-plus, value add, and opportunistic (also known as ‘ground up’). The scale begins with the lowest risk, lowest return core product, typically located in a major metropolitan area, think downtown office buildings with credit tenants and no deferred maintenance or upgrade potential. This is the ‘treasury bond’ end of the commercial real estate spectrum. At the other end is the ground up development where land is acquired and a building erected. These types of investment come with market risk, construction risk, and timing risk – but offer the highest potential returns.
Putting This into Practice
The largest institutional investors, pension funds, are investing more into commercial real estate. There are probably two main reasons for this: low occupancy rates across most real estate sectors makes CRE a “safer” investment, while adverse reaction to stock fluctuation drives investors away from the stock market.
Situations like these allow commercial real estate to serve to balance a portfolio, which is part of the reason why we diversify in the first place. Endowments and VHNW investors also use commercial real estate for similar reasons.
Indeed, making the decision to use real estate to diversify an investment portfolio to achieve greater stability and growth potential is a strategy employed by the largest and best regarded fund managers in the world. But real estate is not a monolithic investment category, much in the same way stocks and bonds are not.
The best way to determine how to invest in real estate is to identify the risk return profile of the money being allocated. If higher risk/higher return is the diversification logic for investing in real estate, the investor is going to tend towards value add and ground up opportunities. If stability and low risk is the objective, core and core plus deals would better suit the investor.
As with any kind of investment, looking to the integrity, experience, and credibility of the management team is going to be the most important criteria in ensuring that the investment meets the intended objectives.