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The two more popular types of investments for passive real estate investors are core and core plus. In this article, we will take a closer look at each and explain the differences between core and core plus real estate investments.
A growing number of investors today are considering commercial real estate as a way to diversify investment portfolios. New trillion-dollar tax-and-spend government programs. As well as the threat of inflation, and rising interest rates. All make real estate an attractive investment alternative to traditional stocks and bonds.
What many investors may be unaware of is that commercial real estate can generate reliable monthly income. Similar to a dividend-paying stock, while at the same time preserving investment capital in the same way that a bond does.
What are Core Real Estate Investments?
The word “core” in investing refers to assets that have virtually no risk in exchange for very predictable income streams.
In the stock market, companies such as Johnson & Johnson, JPMorgan Chase, and 3M are ranked by U.S. News & World Report as the 10 best blue-chip stocks to buy for 2021. These companies have a large share of the markets they operate in. They are worth hundreds of billions of dollars, and pay dividend yields higher than the rate of inflation.
United States Treasury securities (also known simply as Treasuries) are another example of a core investment. U.S. government debt is issued by the Department of Treasury and backed by the full faith and credit of the government.
While blue-chip companies may encounter short-term operating risk from time to time. For example economic downturn or a materials shortage.
Government securities are arguably the safest form of investment. However, that safety comes at a price for investors. This is since current treasury yields are well below the reported rate of inflation.
Investors looking for assets that provide risk-adjusted returns that are greater than what a Treasury bill pays, and with a low correlation to stock market volatility, often turn to core real estate investments.
Class A Property “Core”
In real estate, the word “core” refers to Class A property. Those that are located in the best locations, leased to high-quality tenants and purchased using very little debt. Cash flow from core real estate is consistent and predictable. Often times too can be resilient during economic downturns or a longer recession.
Because core real estate investments have relatively low risk and generate reliable returns. Investors often compare core real estate to blue-chip companies or bonds. The difference is that core real estate often provide annual returns of up to 10%. While the safest equities and bonds pay annual dividends of around 3% or less.
Every commercial real estate asset class – office, retail, industrial, and multifamily – has core property. However, investors seeking the best core real estate investments often focus on multifamily property.
According to a white paper from the National Multi Housing Council (NMHC) titled Explaining the Puzzle of High Apartment Returns. Multifamily property generates the highest returns for the buy-and-hold real estate investor looking for passive income over the long-term.
Why Invest in Core Real Estate?
Investing in core real estate such as multifamily can be a good choice for investors seeking to preserve capital, while also generating risk-adjusted returns over a long holding period.
A recent report from J.P.Morgan Asset Management explains why core real estate assets are essential in today’s low-return world. A traditional 60/40 portfolio of stocks and bonds is the most expensive it has been in 35 years.
Low expected returns from stocks and bonds and even lower interest rates are leaving investors starved for income. Core real estate assets are a “real” solution for earning hard-to-find income and a hedge against the risk of higher inflation and higher interest rates:
Related Link: How to Invest in Real Estate Using Your IRA
- Core real estate looks cheap relative to credit with expected returns well above what will be available from both high yield and investment-grade corporate bonds over the next 10 to 15 years.
- U.S. core real estate can increase portfolio efficiency by offering higher returns and lower volatility with less sensitivity to inflation.
- Because core real estate returns generally come from cash flow and not asset appreciation, core real estate offers a unique opportunity for cash flows to adjust if inflation begins to rise while simultaneously providing a direct benefit to the tenant.
In addition, core real estate normally requires no new improvements that would adversely impact net income. That is because core property is either brand new or has recently undergone significant updating and repositioning.
Another reason for investing in core real estate is those core investments are relatively more liquid than other types of real estate. For example such as value add or opportunistic properties.
Core real estate can be generally easier to sell than other property types. This is simpily because they are stabilized, located in the best areas, and generate reliable returns that are attractive to other investors focused on cash flow over the long term.
Limits of Core Real Estate Returns
Because core real estate is newer. Core investments may not offer a large increase in market value. However, instead they provide recurring cash flow that is stable and predictable with a low level of risk.
To illustrate, let us look at two multifamily investment scenarios. As well as the IRR generated over a 5-year holding period using an IRR calculator:
Core multifamily return
The core multifamily investment is fully updated and located in one of the best areas for great tenants. The property is fully stabilized and leased to quality tenants. Cash flow is predictable with rent rates increasing by 5% each year.
- Purchase price = $5 million
- Annual cash flows = $400,000 with 5% annual increases
- Sale price = $6 million
- IRR = 11.89%
Value add/opportunistic multifamily return
The value add/opportunistic multifamily investment requires significant updating, resulting in zero net cash flow generated in the first year. The property is located in a less desirable part of town, with higher operating expenses.
In the second year, this property is stabilized with an annual cash flow of $300,000 increasing by 3% each year.
- Purchase price = $4 million
- Annual cash flows = $0 the first year due to improvements, then $300,000 in year two with 3% annual increases thereafter
- Sale price = $6 million
- IRR = 13.47%
At first glance, core real estate may appear to be less attractive than the higher yields from commercial properties acquired using a value add or opportunistic investment strategy. Assets like these may be interesting for investors willing to take on a higher level of risk.
The value add/opportunistic multifamily investment requires significant updating, resulting in zero net cash flow generated the first year
Although the value-add/ opportunistic property promises a higher IRR. The property is also more management intensive, and because of the location and tenant demographics may not actually achieve the promised returns or the projected sales price.
Passive real estate investors, on the other hand, view core real estate as a good investment to earn reliable passive income, similar to publicly traded blue-chip companies or government bonds.
When everything is said and done
Often the core real estate investor will choose to invest in a property with higher and more predictable annual cash flows. Rather than investing in a less desirable property and waiting until the property is sold in the hope of earning a larger return.
What Are Core Plus Real Estate Investments?
A core plus real estate investment is one step up the risk and return ladder from a core property. Although the locations may be a little less desirable and cash flows more variable. Core plus properties are rented to good quality tenants.
Examples of a core plus property could include a Class B multifamily property with deferred maintenance. It could also be an apartment building where some tenants are on month-to-month leases. Or it could be a case where some leases are due for renewal in the next few months.
Investors in core plus real estate expect a slightly higher return in exchange for a slightly higher level of risk. Owners of core plus property may be able to increase cash flow by making minor property improvements. They could also increase the management efficiency with the application of cutting-edge technology, which in turn can improve the quality of the tenants.
Although cash flow from a core plus property may be more variable. It can also produce higher potential returns. Especially for investors with a somewhat higher tolerance for risk who are also looking for capital growth.
We will use the following example to illustrate the difference in IRR between a core property and a core plus property:
Core multifamily return
The scenario for the core multifamily property will be the same as the one used earlier. The property is completely updated and in the best location, with predictable cash flow from quality tenants, and held for five years.
- Purchase price = $5 million
- Annual cash flows = $400,000 with 5% annual increases
- Sale price = $6 million
- IRR = 11.89%
Core plus multifamily return
The core plus property requires updating at the time of purchase, resulting in lower cash flow than in subsequent years.
At the time the property is sold. Ownership is able to recover the cost of capital improvements plus profit from appreciation during the 5-year holding period.
- Purchase price = $4.75 million
- Annual cash flows = $325,000 first year due to tenant stabilization and technology improvements, then $350,000 in year two with 5% annual increases thereafter
- Sale price = $6.25 million
- IRR = 12.54%
Although there is slightly more risk with a core plus property compared to a core property. Investors can mitigate that potential risk by working with a general partner to improve operational efficiencies and management.
Growth in rental income can be realized incrementally through strategic improvements that command higher rents, lower turnover, and more lease renewals.
Differences Between Core and Core Plus Real Estate Investments
There are several key differences to be aware of when choosing between a core and core plus real estate investment opportunity:
Core properties are generally in the best urban and suburban location.
Core plus real estate is also located in good areas where population and employment is beginning to grow.
Core real estate properties are brand new or recently renovated, requiring little or no additional capital improvements.
Core plus real estate investments may need some improvements to stabilize the tenant base and increase incremental cash flow.
Tenants in both core and core plus properties are generally high quality.
Core plus real estate may have a larger than expected percentage of leases renewing in the near term, as well as some leases on month-to-month.
Core real estate generally has stabilized occupancy levels and rents at or above market, generating predictable recurring cash flow year after year.
Core plus properties may require more active management at the time of acquisition to stabilize the tenant base.
Both core and core plus real estate use conservative leverage. Loan to value (LTV) ratios in core investments may average 40%.
Core plus properties sometimes have LTVs of 60% to 70% so that more investor capital can be used for minor updating and technology improvements.
Both core and core plus properties provide investors with stable, bond-like returns over the holding period. Oftentimes, core real estate investments are held for 5 to 10 years.
Core plus properties may change hands after a 5-year holding period.
Returns on core real estate come primarily from the annual cash flow generated, because brand new or fully renovated core properties generally appreciate less.
Core plus properties generate returns for investors from annual cash flow plus returns from capital appreciation.
Conclusion
Generally speaking, a core real estate investment could be a good fit for older investors seeking reliable income and capital preservation. On the other hand, investors choosing core plus property are willing to accept a slightly higher level of risk in exchange for a slightly larger return.
Commercial real estate investors should consider
how core and core plus real estate investments match an investor’s
strategy, holding period, and balance of risk to anticipated returns.
With both core and core plus investments, working with a private equity sponsor can help minimize risk and increase potential returns. Especially for investors looking for passive income from real estate over the long term.
Do you want to learn more about how Smartland invests? Contact us today and see if a real estate investing strategy is the right choice for you!
