In Part 1, we looked at core and core+ strategies which form the bedrock of a diversified real estate portfolio.

 

In Part 2, we'll look at value-added and opportunistic strategies which increase returns. Finally, we'll look at what percent of your portfolio should be allocated to each of the four strategies, and when. 

 

Value-added

 

Historic rates of return: 10 to 15%

Leverage: 40-70%

Risk: moderate to high

Value-added strategies involve:

 

1. Purchasing real estate at a lower price because it is moderately distressed in some way (rundown, poor management, etc.)

2. Getting a loan to improve it.

3. Selling it for a (hopefully) higher price that covers the cost and makes a profit.

 

For example, you might invest in a rundown strip mall without many tenants and renovate it. Once it has lots of tenants, you can sell it for a healthy profit. Or you might purchase a home that is rundown. After fixing it up, you can “flip it” for a profit.

In addition to investing in the equity of the investment, you could choose to invest in the debt (finance the loan). (See “what’s the difference between equity and debt?”)

 

Much of the risk in value-added strategies comes from the fact that they require moderate to high leverage to execute (40 to 70%). Leverage does increase the return, but also increases the risk, and makes the investment more susceptible to loss during a real estate cycle downturn.

 

So awareness of the real estate cycle and timing are crucial before investing.

The area in green indicates the points in the cycle when value-added strategies are typically implemented. The earlier in the cycle, the greater the number of good opportunities and the lower the risk. Risk increases as the cycle progresses and less and less good opportunities are available. By the end of the green area of the cycle, it's a very bad time to invest. And in areas of the cycle where there is no green, it's so bad to invest that there are usually no investments available.

 

 

 

 

 

Timing is so important that many academic studies have found that most of the return from successful value-added (and opportunistic) strategies, came from proper timing, rather than special skill of the operator (assuming they are at least competent). If properties are not sufficiently distressed and/or debt is not sufficiently cheap, the investment is unlikely to succeed (see Depaul University study).

 

Also, strategy must be executed as planned. If it’s more difficult, or more expensive, then you might not make the projected return, or could take a loss.

 

Value-added strategy assets can be in safer primary locations, or riskier secondary locations.

 

Commerical vs. Residential value-added

With commercial investments, the asset type can be any of the conservative “Big Four”, or a specialty asset (self storage, entertainment, medical offices, student housing). The profit comes from a mixture of income (40 to 70%) and price appreciation (30 to 60%). Since the strategy can take years to execute, some investors will only purchase during pricing drops (when assets are significantly distressed and which allows for selling in the next up cycle). Others do it later in the cycle which can also work, but involves more risk.

 

With residential home investments, the house can’t usually be rented during renovation. So the profit has to come 100% from price appreciation, which makes it more risky than commercial.

 

Fortunately, that disadvantage is offset by the fact that the strategy can be executed in as short as a few months. This allows residential investments to be initiated and repeated many more times during the upcycle.

 

Opportunistic

 

Historic rates of return: 12% plus
Leverage: 50-80%

Risk: high

 

Opportunistic strategies target highly distressed properties that require major renovations. They also involve the development of raw land, into residential or commercial properties.
 

This strategy is the riskiest, because it involves the use of high leverage (50 to 80%), and the improvement plan is much more complicated than “value-added”, and susceptible to surprises. Additionally, there are usually significant periods of construction when no income can be generated. And often, income can only be slowly built up once that period ends, and may never be built up at all.

 

That’s why 70%-100% of the return of an opportunistic strategy comes from appreciation of the property, rather than income.

 

As discussed under “value-added”, studies have shown that timing is crucially important in an opportunistic investment, to avoid losses. 

In the graph below, opportunistic investments are possible in the red and blue sections of the cycle. They are safer and less risky at the beginning, and increasingly dangerous as it progresses. In areas of the cycle with no red or blue, it's not cost feasible to create an opportunistic strategy, and those investments should be completely avoided.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Opportunistic strategies can be implemented on primary, secondary or tertiary markets. It can involve conservative asset types “The Big Four”, as well as the riskier specialty types.

 

You can invest in opportunistic equity strategies or debt.

 

Debt can be either senior or mezzanine.

 

The interest on senior debt paid first, which makes it safer, and normally has moderate interest rates. But when the asset is sufficiently distressed, the interest rate jumps high enough to be useful in the strategy.

 

Interest on mezzanine debt is paid after senior debt, and has longer 5 to 10 year maturity terms. (It also has a higher chance of losing principal, because it doesn't have the physical property as collateral, but instead the option to convert to equity in the parent company). So it pays higher interest, but is also riskier.

 

How much should I allocate to each strategy?                                            

Meketa Group, studied the returns of different strategy allocations, and how to construct the most efficient and safest portfolio.

 

They found that:

 

1. The safest portfolios were 80% core investments (core and core+).
    

2. It's possible to eke out up to 1.5 percentage points more by increasing the amount of value-added and opportunistic up to 60% together. But doing so also ratchets up the risk as well. 

 

 

 

 

 

 

 

 

However, these results could be a little misleading, and perhaps not as useful as they first seem.

 

Maketa studied the risk based on a "dumb portfolio" that invested equally at all points of the real estate cycle.

But a savvy investor may not invest this way. Smart investors (hopefully) only invest in value-added and opportunistic at the appropriate point of the real estate cycle. And they avoid them at inappropriate points. This could substantially reduces the risk below what's stated above.
 

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Allocate based on your risk tolerance

 

Many real estate investment advisors go a completely different route. Instead, they recommend that you look at your own risk tolerance.

You should devote more to conservative strategies if your risk tolerances conservative or you are income focused. And that you devote more to aggressive strategies if you're the opposite. Here's a very typical recommendation:
 

• Conservative/income focused investor:

  • Core: 80% (+/- 20%)

  • Value-added: 15% (+/- 10%)

  • Opportunistic: 5% (+/- 5%)
     

• Moderate/balanced focused investor:

  • Core: 50 % (+/- 20%)

  • Value-added: 30 % (+/- 10%)

  • Opportunistic: 20% (+/- 10%)
     

• Aggressive/appreciation focused investor:

  • Core: 10 % (+/-10 %)

  • Value-added: 50 % (+/- 10%)

  • Opportunistic: 40% (+/- 10 %)

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Go with the flow
 

Ultimately, it can be difficult to achieve an exact number, depending on where you are in the cycle. For example, if you are in the recovery phase of the real estate cycle, it simply isn't cost feasible to create new construction. No matter how much you would ideally like to allocate to opportunistic investments, you just won't be able to allocate any (not good ones, anyway).

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If you're in the last part of the hyper supply phase of the cycle, the opportunities for decent value-added investments will have long disappeared. Again, you probably won't find any, and if you do you probably want to stay away.

 

So ultimately, the savvy investor is less concerned with the ratio, and more concerned with putting themselves into the proper strategy type at the proper time.

 

Addtionally, Meketa Group recommends diversifying by strategy type, geography, property type, employment base, manager, vehicle, individual investment and vintage year. So investing over multiple years may not be such a bad idea.