In Part 1, we covered core and core+ strategies. In this Part 2, we’ll go over value-added and opportunistic strategies. Both go up on the risks and returns spectrum.
Medium-to-high-risk/medium-return strategy. This involves acquiring an existing asset with specific plan to spend meaningful dollars to upgrade an asset’s aesthetics (could be interior or exterior), alter its physical composition and / or drive revenues through increasing operational and/or management efficiencies, strategically improving it in some way(s), and disposing at an opportune time. For example, you might invest in a rundown strip mall without many tenants and renovate it. Once the retail spaces leased up and occupancy stabilized, you can sell it for a healthy profit. Or the project could be to purchase an apartment complex that requires upgrades, trimming of expenses and/or occupancy enhancement, or all of the above. After executing the plan (or while work-in-progress, a too-good-to-refuse purchase offer surface), the Sponsor sells for a profit.
Much of the risk in value-added strategies comes from the fact that they require moderate to high leverage to execute (40 to 75%). Leverage amplifies return, but also amplifies the risk, making the investment more susceptible to loss during a real estate cycle downturn if the debt cannot be serviced). Awareness of the real estate cycle and timing, coupled with deal-specific loan terms are crucial before investing in this strategy. Suffice to say, the earlier in the cycle, the greater the number of good opportunities and the lower the risk. Risk increases as the cycle progresses; less and less good opportunities are available.
Higher-risk/high-return strategy. Opportunistic strategies target highly distressed properties that require extreme makeovers, fraught with major structural or financial distressed (e.g. purchased as foreclosed property or through liquidation sale of a bankruptcy, i.e. workout or special situations). This strategy is the riskiest, could be drawn out in time, with outcome tied to uncertain court ruling or decision of a lender (or other lien holders or decision makers), and the improvement plan is much more complicated than “value-added” and susceptible to surprises. There could be long periods of no income or worst, no income ever. Majority of the return of an opportunistic strategy comes from appreciation, if any, or the final exit value, of the property, rather than in-place cashflow.
How much should I allocate to each strategy?
We are not here to doll out investment advice. Common sense dictates that one should allocate based on one’s risk tolerance and unique financial circumstances. Yes, thank for stating the obvious, I know. There is no one-size-fit-all allocation ratio. You should devote more to conservative strategies if you are risk adverse; devote more to aggressive strategies if it fits your risk appetite. Don’t bite off what you could stomach. If certain risks keep you up at night and you could see yourself losing sleep over it, then don’t invest in it.
To make things harder, besides one’s risk tolerance, timing – by that I mean where we are in the real estate market cycle – should also be considered. A sizable portion of the return from successful value-adds can be attributed to proper timing, rather than special skill of the operator. Does “rising tides raise all boats” ring any bell? Arguably and depending on the “situation”, skills and experience of a sponsor play a bigger role in opportunistic strategies I dare say.
Ultimately, I would worry less about finding the major formula on allocating among the four strategies and more focused on going with the proper strategy type at the proper time, loosely speaking. One could also consider diversify by strategy type, geography, property type, employment base, manager/operator, vehicle, individual investment and fund.