Top 4 Strategies to Invest in Commercial Real Estate

David Cohn
Jun 14, 2021
CRE Investment

There's no such thing as a one-size-fits-all strategy when it comes to commercial real estate investing. Different investors have varying objectives, time horizons, and risk tolerance.

For example, conservative investors may have the goal of generating reliable passive income. Beginner investors may have a shorter-term time horizon.

Seasoned investors with longer-term outlooks, on the other hand, may be able to afford some risk. Luckily, there's more than one type of CRE investment strategy, each of them varying in terms of (1) their risks and (2) the returns they can offer.

The general principle of low risk/low return and high risk/high return applies in most cases. It's important to understand these strategies' risk and return profiles so you can decide on your first investment or diversify your portfolio.

It also makes sense to look at a few key factors to differentiate the four strategies:

  • Amount of debt and leverage used (how much money needs to be borrowed for the deal)
  • Location of the property and tenant demand
  • The physical condition of the asset (excellent condition, needs repairs, unsatisfactory, require significant rehab)
  • Property type (industrial, office, multifamily, etc.)
  • Current leases and their lengths (long-term vs. short term)

With these in mind, discuss each strategy and what they mean.

Strategy #1: Foundational Investments (also called Core Investments)

Commercial real estate investments are the most stable and least risky; foundational properties are considered the bedrock of a solid portfolio. They tend to remain reliable through different phases of market cycles.

Foundational investments usually refer to rental properties that have the following characteristics:

  • Newer (or like-new) condition
  • Low leverage (50% to 60% of the value of the property)
  • Full or near full occupancy rates
  • Long-term leases
  • Strong tenants
  • Operating at full capacity
  • Little to no deferred maintenance required
  • Fully stabilized
  • Low level of active management necessary
  • Positioned in 'good' to 'great' locations in either primary or secondary markets

These types of properties tend to generate a positive cash flow right from the start. They also command the best terms and lowest interest rates from banks and other commercial hard money lenders because of their quality.

Examples of foundational investments include Class A multifamily buildings in primary and triple-net leased properties to credit tenants on long-term leases.

Fully tenanted buildings designed for medical offices located in high-demand areas also fall in this category.

Note that high-quality foundational assets are not the cheapest. They are turnkey properties that usually cost a significant amount of money—which means that they also offer lower potential returns, averaging just 4% to 8% every year.

While investors can expect capital gains as time goes by, such gains would likely be on the low side.

Foundational investments attract commercial real estate investors who are relatively averse to risk, have short-term time horizons, and prefer income stability to capital gains.

Such investors are generally older. Their primary goal is to preserve their capital and implement a hold strategy.

For them, cash flow is more important than property appreciation, and you should avoid volatility as much as possible. Foundational investment properties can also be suitable for new CRE investors in the beginning stages of building their portfolios.

Strategy #2: Foundation Plus Investments (also called Core Plus Investments)

These CRE investments are riskier than foundational assets, but they may also offer slightly higher returns. These properties have the following characteristics:

  • Higher leverage (between 55% to 65% of the value of the property)
  • Somewhat dated
  • Low to medium vacancy levels
  • Minor deferred maintenance necessary
  • Tenants are local or regional
  • Leases are medium to long term
  • Good (not great) locations in either primary or secondary markets

Examples of properties in this investment class include Class B multifamily apartments or office buildings that need minor cosmetic repairs and have a little vacancy. Old medical facilities requiring updates and other similar properties with leases set to expire soon also fall in this category.Investors using this strategy expect returns of anywhere from 8% to 12% every year for taking on a slightly higher level of risk.

Strategy #3: Value Investments (also called Value-Add Investments)

For investors who are willing to manage additional risk, value investments may be a good choice. Commercial properties in this category have the following characteristics:

  • Dated condition/needs updating
  • Not operating at its full capacity
  • Medium to high leverage (sometimes as high as 75% of the value of the property)
  • Medium to high vacancy levels
  • Leases are expiring soon, with renewal uncertainty
  • Presence of operational issues requiring skilled operators/managers

Contrary to popular belief, value investments don't necessarily have to be in 'bad' areas. They can be located anywhere—from marginal locations to great locations.

What sets them apart is the fact that they have operational, financial, or physical issues?

One example of value property is a poorly-managed and dated apartment building with below-market rents and a vacancy rate of 20%.Investors who put money in this type of strategy expect a return of 13% to 20% every year.

The profits can be a mix of property appreciation and income. It's essential to have a solid business plan for renovating in improving the asset to increase its rent rates, net operating income, and property value.

Those who have experience in improving problematic commercial properties may successfully stabilize value assets before selling them for a profit.

This commercial investment strategy may be a good fit for investors with high degrees of risk tolerance and longer-term horizons.

Such investors focus on the upside potential of an asset, confident that they can improve its cash flow and benefit from increased gains when they sell a later.

Strategy #4: Speculative (also called Opportunistic Investments)

Speculative commercial real estate assets carry the highest level of risk, and because of that, they also offer the highest return potential. They have the following characteristics:

  • Located in marginal areas
  • High leverage
  • Significant financial, occupancy, management, structural, or operational issues

Some examples of speculative CRE investments include repositioning a building (changing its use), empty buildings, and ground-up new developments.

They often don't produce any income for multiple years, but they have the potential to deliver handsome rewards—usually much more than 20%—for successful investors.

Speculative CRE attracts people who have the stomach for many risks, have long-term time horizons, and can afford to wait many years for their investment to produce income. They see the big picture and don't expect immediate cash flow.

Which strategy is right for you?

Before you decide on a commercial real estate investment strategy or a combination of these strategies, you first need to clearly understand (1) your goals and (2) your risk tolerance.The key is to match a strategy to the level of risk you're willing to take, your timeline, and your expected returns.

Well-balanced CRE portfolios usually contain investments from different strategies in different proportions.