An Ultimate Guide to CRE Investment Strategies

Key takeaways

• Investing in commercial real estate begins with educating oneself about specific market conditions, asset performance, and learning about the fundamentals.
• CRE investment strategies employ several approaches, but the most common ones are Core, Core+, Value-Add, and Opportunistic. 
• Most investments are either actively or passively managed. 
• Capital allocation, risk and return profiles, and cap rates are three important ways to measure the viability of an investment. 

Types of CRE investment strategies

Core

Most investors are familiar with the buy-and-hold method of investing in commercial real estate. This is known as the “core” investment strategy. This strategy involves purchasing a well-located, Class A or higher building with modern amenities and good cash flow. The investor then holds the property for a specific time period. 

Core+

The Core+ strategy is very similar to Core investment in that they both involve buying and holding assets. The key difference between the two is that Core+ investors often purchase buildings that need some renovations which could include multiple classes of buildings. They may also be in up-and-coming parts of town. 

Value-Add

Value-Add investments are when an investor buys a property that needs a total renovation. This can include maintaining the building’s mechanical and HVAC systems, re-tenanting, restructuring operational expenses, and everything else. These renovations are a key component of the Value-Add strategy because they will dictate whether the asset appreciates at the rate an investor expects and will justify charging tenants a higher rent.  

Opportunistic

Opportunistic investment strategies seek the highest possible return by injecting a building in an emerging submarket with significant capital improvements and business restructuring. It can involve renovating a building from top to bottom, re-tenanting it until it reaches financial stability, repositioning it, or some combination thereof. 

Active vs Passive investment strategies

Outside of the four main investment strategies, investors can also take an Active or Passive approach to managing their investments. Deciding which approach is right for you requires consideration of several factors. These include the amount of time an investor can dedicate to managing their investment and the size of an investor’s overall portfolio.  

Active approaches to investment management require the highest level of commitment from an investor and sometimes can feel like a full-time job. An active investor directly participates in the investment, including the research, due diligence stage, and day-to-day management. This approach also requires an investor to consider how a particular investment meshes with other investments in their portfolio, which can be time-consuming. 

Passive investors take a completely different approach than active investors. This approach to investing involves much less time and attention than active investment strategies and can generate fewer returns because of that approach. Passive strategies include buy-and-hold investments, like the ones a Core or Core+ investor might pursue. It can also include crowdfunding opportunities or investing in real estate trusts. 

Capital allocation strategies

Once investors decide on their investment strategy and management style, they must determine how to allocate their capital to maximize returns. There are five main ways for investors to allocate their funds:

• Operational capital
• Research & development (R&D)
• Growth capital
• Capital expenditures (CapEx)
• Working capital

Operational capital focuses on a building’s day-to-day operations. These funds typically support salary costs, utility payments, and the purchase of the raw materials needed to make a business run smoothly. Some examples include using the funds to upgrade software or purchasing new equipment for a building’s HVAC system. 

Research and development, or strategic capital, is spent on long-term projects like market expansion or acquiring new technology. These expenditures are designed to improve an investment’s long-term sustainability or increase a business’ competitiveness within a specific market. 

Growth capital is similar to strategic capital because both are dedicated to driving future growth. While strategic capital is focused on developing new strategies, growth capital puts those strategies into action. Growth capital is deployed to fund new expansion opportunities or to help a company acquire more market share by launching new products, expanding into new markets, or scaling existing opportunities. 

Capital expenditures (CapEx) involve large, long-term spending on improving an asset’s infrastructure, such as upgrading a mechanical system or making major roof repairs. These expenditures should ensure that an asset’s infrastructure does not hinder a business’ growth opportunities. 

Working capital is used for short-term expenses and liabilities to meet a business’s day-to-day obligations. Overall, it measures a company’s ability to meet its liabilities. This can include accounts receivable and accounts payable or other prepaid expenses. 

Risk & return profile

Investment strategies, management styles, and capital allocation initiatives all create an investment’s risk and return profile. This profile compares the estimated risks with the potential returns for an investment. 

There are typically five steps to create an accurate risk and reward profile.

• First, investors need to identify all potential outcomes of a particular investment. That means creating scenarios where an asset is fully leased, and when the asset is vacant.
• Next, investors need to measure the financial outcomes for each scenario, usually noted as 0X, 1X, 2X, and so on. Scenarios where a 0X return is expected mean the investment has failed. A 2X return means an investment returns two dollars for every dollar invested. 
• Third, investors need to measure the likelihood that each scenario will come true, which is usually expressed as a percentage. The sum total of all these probable scenarios must equal 100%.
• Next, investors must measure the expected return from each outcome by multiplying the magnitude outlined in step two by the probability of the scenario coming true that was measured in step three. For instance, a scenario with a magnitude of 3X and a likelihood of occurrence of 30% would create an expected return coefficient of 0.9. 
• Finally, investors must add together the coefficients of the expected outcomes to determine an investment’s composite score, which determines its viability.  

Cap rate in CRE investment strategies

Another way to measure an investment’s viability is its capitalization rate or cap rate for short. Cap rates are calculated by dividing an asset’s net operating income by its market value. For instance, if you have a property worth $10 million that generates $1 million in net operating income, the asset’s cap rate is 10%, which is a very high mark. 

Cap rates can also measure the impact of economic conditions, market competition, monetary policy, and real estate regulations on a particular investment. If the $10 million property mentioned above sees its cap rate fall to 8%, it can signal to an investor that outside forces are affecting its asset’s returns. 

How to Invest in CRE

Investing in commercial real estate begins with education. Before making a decision about purchasing an asset, an investor should be well versed in a specific market’s conditions. The investor should also understand their investment strategy, and secure financing opportunities. 

There are several ways to invest in commercial real estate that involve something other than actively managing an asset or portfolio. Investors can buy into crowdfunding funds or real estate investment trusts. Third parties such as private equity firms manage these portfolios of properties. 

FAQs – CRE Investing Strategies

What is a good ROI for commercial real estate investments?

An investment property’s return is determined by several factors, such as market performance, capital allocation, and the investment strategy deployed. Depending on the combination of those factors, returns can range from the low single digits to greater than 20%. 

What is the best asset class for commercial real estate?

Investors often consider multifamily properties like townhomes, condos, and apartments as one of the safest investments in commercial real estate because they have consistent demand and can serve a multitude of different tenant types. 

What is the most profitable type of real estate investment?

Rental properties or fix-and-flip investments typically generate the highest returns for investors. However, these investments are often some of the riskiest. 

Conclusion

Investing in commercial real estate is not for the faint of heart. It requires extensive due diligence and market analysis to be successful by advancing your strategies. Investors need to consider their investment approach carefully, the risk-reward profile of an asset, and their capital allocation strategy before spending their first dollar on a new investment.