Investment Risk Classes

Investment Risk Classes

Hey everyone, this is Jennie from Real
Estate English Academy. Today we’re going to talk about the different risk classes
involved in commercial real estate investment. I’ll give you a general
overview and point out some specific terminology that real estate investors
use to navigate and talk about their real estate investments. The interplay of risk and return is a fundamental concept in any investment decision. An
investment is designed to produce an expected return. Return is the term we
use for what an investor gets back on their investment, usually through rental
income, capital appreciation or some combination of the two.
The term rental income refers to the rent a landlord receives each month from
its tenant. Capital appreciation is what happens when the investment property
increases in value. Now, a basic principle of investing is that higher potential
returns, or what an investor hopes to get out of, or earn from, their investment,
generally require a higher degree of risk. And each investor needs to find
their own appetite for risk, which basically means how much risk they are
willing to take. By the same token, every investor has a certain degree of risk
tolerance, or the point at which they’ve reached their limit in terms of risk.
Another way of looking at risk tolerance is how much risk an investor is willing
to put up with or tolerate. Regardless of the risk tolerance, it’s important that
investors understand the risk return dynamics of an investment to make sure
that that investment is in line with their
objectives. Some useful synonyms for the term objective include goal, target and
aim. Okay, now let’s take a look at different risk profiles. Commercial real
estate investments are typically categorized into one of the following
risk profiles. Core, core plus, value add and opportunistic. Core assets exhibit
the lowest risk and the lowest potential return. These assets are suitable for
conservative investors. This risk profile typically produces low to moderate
capital appreciation in the short term. So, although investors shouldn’t expect
spectacular returns from core investments, they can expect to see their
investment perform, which means it should, over time, bring the investor the return
they were hoping for. Core assets usually exhibit high occupancy, strong covenant
tenants, long lease terms (ten plus years) and prime locations. Now, let’s take a
closer look at what that actually means. High occupancy is important because it
means that there’s very little to no vacancy at the property, so investors
won’t have to spend their time and energy trying to lease or find a tenant
for vacant rental units. Strong covenant tenants have excellent credit scores,
which means the chances that they will default, or be unable to pay the rent,
are low. Leases with long terms are also important because a long lease term
means that the tenant will be staying at the property for several years and there
won’t be a need to invest in renovating or trying to release that space anytime
soon. Another benefit of core investments is
that financing is easily available under normal market conditions. That means it
shouldn’t be too difficult for an investor to go to the bank and take out
a loan to help them purchase that property. Okay, now let’s talk about core
plus. Core plus assets have slightly higher risk and offer marginally higher
potential return. This slightly higher return may come from the opportunity to
increase operating income because the lease is set to expire in the near
future or by filling small vacancies. Even though that means more active
management of the property, increasing the operating income of the property
will ultimately mean more money in the bank. Investors can expect moderate
capital appreciation with core plus assets. As with core assets, financing is
widely available under normal market conditions and the holding period is
usually medium to longer term, which means about seven to ten years. The term
“holding period” refers to the period of time between when an investor acquires,
or buys, the property and when they dispose of, or sell, it. Now let’s move on
to value add. Value add assets exhibit medium to high risk and medium to high
expected returns. These assets typically provide the opportunity for improvement,
which is where the name of this risk class comes from, as the investor adds
value by making those improvements. Occupancy and/or rental rates may be
below market level. Another way of saying this is that the property is underrented. Significant capital expenditure, or CapEx, may be required.
CapEx refers to the money that an investor spends on improvements and
other management related expenses. Value add properties offer higher capital
appreciation potential but lower near-term income
security compared to core and core plus investments. It may be more difficult to
secure financing due to the higher risk. Holding periods are usually short to
medium-term, which is about three to seven years. And finally let’s talk about
opportunistic investments. Opportunistic assets exhibit the highest risk and the
highest return potential. They often require substantial enhancement to
generate return. Enhancement in this case is another word investors may use when
they talk about improvement to a property. Opportunistic investments may exhibit
low or even negative initial yields. Initial yields is a term that you
use to describe the initial return that an investor can expect from their
investment. Total returns have the potential to be exceptionally high with
opportunistic investments, but the associated risks are significant.
Financing is often highly dependent on the business plan for the asset and the
investor’s track record, which basically describes the performance history of
that investor. Have you ever made an investment in any of these risk classes?
if so, let me know in the comments below. And if you liked this video and want to see
more, subscribe to our channel and hit the bell button to turn on
notifications. And if you want to test your knowledge of risk classes, click on
the link in the video description and take our quiz. See you next time!

2 thoughts on “Investment Risk Classes

  1. hi

  2. Where do you find all of these for us

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