Real estate investors have individual risk/return requirements, but they may not be familiar with the four main types of fund categories. As a result, investors need to carefully study them: Core, core plus, value add, and opportunistic. Learning about each type of portfolio helps to ensure that investors are comfortable with factors such as the quality of the buildings, the location of the assets, and the properties’ capital structure. The definition can vary from sponsor to sponsor, but these four broad categories communicate the funds’ expected risk and return profiles. This article focuses on core and core plus.
Core Real Estate Funds
Core real estate funds represent the most conservative blend of risk and return in the private real estate segment. These funds invest in core properties of the highest quality, located in great areas, and are not burdened by many deferred maintenance requirements.
Core is considered a less risky strategy because these portfolios target stable investments, usually fully leased properties in primary markets, also known as class A locations. Class A properties boast a high credit score and have signed tenants for long-term leases. Investors choose this strategy to obtain regular cash flow, stability, and relatively low risk. Experts evaluate that these funds will generate annual returns of 6% to 10%.
Core features relatively new properties in great locations, which can attract the top tenants. As a result, the buildings will feature superior cash flow, low tenant churn, and low debt or leverage. The funds can generate consistent returns over time. The bottom line is that investors can expect few, if any, surprises with these assets. Investors in core real estate funds obtain access to some of the properties’ cash flows. Therefore, current income represents the majority of the fund’s return.
Big institutional investors, such as pensions and endowments, favor core funds. For these institutions, the primary advantage of core real estate is its relatively low-risk profile. In addition, core real estate funds can often accept large amounts of capital, a vital consideration sought by institutions with significant amounts of money to invest.
Regarding disadvantages, core real estate funds offer a limited potential for appreciation. As a result, they are less appropriate for investors seeking growth or a blend of income and growth. Low risk generally correlates with low return. The returns of a typical core real estate fund may not be high enough to satisfy some investors’ financial goals.
Core Plus Real Estate Funds
Core plus is best understood by comparing it to the core strategy. Core plus funds invest in properties that are similar to core properties, but, for one reason or another, they do not quite fit in the most conservative category. Core plus has a low to moderate risk profile. Typically, core plus properties are 10-20 years old and situated in good but not great locations. These properties may also be burdened with deferred maintenance and leases close to expiration.
The core plus strategy is about purchasing stable, income-producing assets with relatively low risk profiles, similar to core investing. Core plus managers seek properties with a history of income production and a proven ability to continue to produce income distributions to investors.
Individual or institutional investors can add a core plus property allocation to their portfolios by purchasing publicly traded investments like REITs or as part of a partnership with a private equity firm. Typical investments include multi-family properties and other types of commercial real estate.
How Does Core Plus Differ?
Differences between core and core plus can be subtle. Core plus does have moderate risk. For example, the properties may have tenants with leases about to expire. On a yardstick from safest/lowest return properties to highest risk/highest return, core plus properties are positioned between those two points.
Take an asset in a Class A location in the city’s booming downtown. If the building is Class A, it would be considered a core asset. However, if the building is Class B or C, perhaps an aging office building from the 1970s, it would belong in the core plus bucket.
Another contrast between core and core plus is that core plus may achieve a higher rate of return due to leverage or debt. A Class A building in a Class A location would typically fall in the core asset category. However, if the manager takes on more leverage than usual, i.e., leverage of 60%, 65%, or 70%, then the asset is core plus due to the higher risk profile.
Core plus assets are typically income-producing properties that are well leased—perhaps not to the absolute highest quality tenants, as you would expect with a core asset. However, the tenant base is creditworthy, and it has leased its space at a high rate over time. Most core plus assets are stable. As a result, they do not require a buyer to take on extensive renovations or discern a method to boost occupancy from 50% to 95%.
Since core plus assets are often more challenging to purchase and have few bidders from large institutional buyers, the core plus portfolio benefits when purchasing properties. The core plus manager can buy the properties at an attractive price, perhaps due to issues with the property, such as being outdated or maintenance, which must be addressed.
Once purchased, owners can boost cash flow by addressing renovations or repairs and signing higher-quality tenants. The need for improvements with the core plus properties may be higher than with the core, but these efforts can be rewarded with a higher appreciation of the asset over time.
As a result, these buildings potentially have a more significant upside when sold.
The core plus return profile is typically an 8%-12% annualized return with a similar level of cash flow as a core portfolio, 6% up to 8%. The rest of it is additional growth in the value of the portfolio’s assets. Due to the higher risk compared to core, core plus investors have a higher expectation for returns. Due to core plus’s moderately higher risk profile, these assets have the potential for a measure of price appreciation.
These investments may be best suited to investors with a relatively small desire for risk and perhaps an interest in a measure of capital appreciation.
Core Plus Risks
A potential risk of a core plus real investment is less cash-flow predictability than a core investment. These investments often require that the owners address various maintenance issues. An example of a core plus property is a 15-year-old apartment building almost fully leased but in need of repairs and/or improvements. The property generates robust cash flow, but some money may have to be earmarked for future maintenance, such as fixing the roof or repairing the parking lot.
Other risks involve Class A properties in Class B locations or Class B buildings in Class A locations. Both cases have different risks. A tenant in a Class A building in a Class B location may view the location as lower in value. As a result, the tenant may move to a better location during a recession if offered lower rent. As a result, the owner may lose tenants who desire to move to a better location.
Likewise, a Class B building in a Class A location may require more deferred maintenance. The building owner may have to allocate some of the rent normally distributed to investors, and use part of it for repairs, deal with a mechanical failure, or respond to other issues as buildings age.
Core plus managers may also use higher levels of leverage or debt than core.
Conclusion
Investors in core plus portfolios can expect an annual 8%-12% rate of return, which compares favorably with stock market averages. However, these assets are in the second lowest real estate investing risk category. Core plus represents an excellent combination of risk and return for investors who desire stable income in their portfolios.
Knowing the difference between core and core plus is crucial due to the different levels of risk. A risk-averse investor with an interest in income may invest in excellent properties with little leverage. Investors willing to take on a higher level of risk may choose Core plus to obtain superior returns.
When considering whether a core or core plus real estate fund might be a good fit for your portfolio—or any private real estate investment, for that matter—it’s important to first establish a foundational framework.
Key components include:
- Defining short-, medium- and long-term financial goals
- Considering whether your priority is a passive income stream, build wealth, or something in between
- Understanding your risk tolerance
- Assessing your ability to hold illiquid investments
Most individual investors will benefit from the support of financial, tax, and legal advisors throughout the asset allocation and portfolio construction process.
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