#84: Understanding The 4 Main Commercial Real Estate Investing Strategies

Welcome to the Passive Income MD Podcast, where we talk about creating your ideal life through multiple streams of income. I'm your host, Peter Kim. If you enjoy hearing about this stuff, make sure to hit subscribe so I can bring it to you every week. Now let's get on with the show. Hey, everyone, it's Peter. Hope you're having a great week. Before we get to this week's episode, wanted to let you know that we have an end of the year community survey. This is in 2021, whenever you're listening to this, but we want to know a little bit more about you, who you are, who's listening to this, who's reading our stuff, who's part of our community. And we want to know all these things because we want to know how to better serve you, give you the best resources and opportunities out there to help you on your journey to financial freedom and really just creating the life that you love. Now, it's just a way for us to get to know you better. Again, the answers are strictly confidential. 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It would mean so much to us to get to know you and really just help continue to push our community forward to do better things for ourselves, for our profession and things like that. So again, the link is passiveincomemd.com survey2021. All right, so let's get to this week's episode. Okay, so I've heard from many of you that this podcast has helped you on your journey to investing in real estate. Whether it's owning your own rental properties that's like your active real estate Investing or your more passive real estate investments, where you've invested in other people's deals. So when you're looking at deals, whether it's for your own properties or in other people's deals, it's really important for you to understand the four main real estate investing strategies, especially when it comes to, like, commercial or larger projects. And it took me a while for me to understand these things. I saw these names like this terminology keep popping up again and again and again, and only when I finally understood what they meant, it kind of opened up the world to me in terms of, like, looking at deals. Now, when it comes to investing, right, we all know that there are two major components at play, risk and return. It's important to understand how they're correlated because, you know, if you want to become a successful investor, you need to really maintain, I'd say, a really delicate balance between the two and know what works for you. You know, just generally speaking, the lower the risk, the lower the return, and the higher the risk, the higher the return. And so understanding the different strategies for any type of investing, commercial real estate, it kind of follows along this path, right? So it's important to understand these four investment strategies. And they're. I'm going to just go list them out right now and then we're going to talk about each one. First one is core. It's called core, C O R E, core plus value add and opportunistic. So let's go with those four again. Core, core plus value add and opportunistry. It's important to familiarize yourself with these because these, again, this terminology, terminology gets thrown around quite a bit, or at least like when you see a deal, you can stratify it and put it into one of these buckets so you can understand where the risk is, what the return potentials are, and see if it makes sense for you. Now, it's really important because at certain points in the market cycle, certain strategies help you stick to the level of risk you're comfortable with. Now, I know many of you have heard that we're at some point in the market cycle. Whether it's near the end, it's in the middle, we're at the very end, the eighth or ninth inning. I can't tell you for sure. Like I don't have a crystal ball and I can't tell you where we're exactly at. But diversifying is probably a great strategy, and figuring out ways to mitigate your risk at this part of the cycle is probably a smart way to go. So when you want to think about these investment categories, like I'm thinking about these couple different key factors, right? And here they are. Number one, the amount of leverage and debt they use, like how much, how big is the loan? Right. Or how much is the leverage on that particular property? So how much do they borrow for the deal as like a percentage? Number two, I want to know about the physical condition of the property. Is it in great condition? Is it ready to go? Does it need some repair soon or is it really poor? Needs a ton of repair and a ton of significant rehab. That's important to know. Also the property location, what is the market like, what's the tenant demand there? And that's something you want to know as well. You know, what type of property is it? Is it multifamily industrial, like a warehouse, office space, whatever it might be, you need to know. And then ultimately, what are the lengths and the terms of the current leases in place? Are these like long term leases, short term leases, and then with all those things in mind, all those categories, you're able to stratify the type of deal or investment into these four main strategies. The first strategy is the core strategy, C O R E. Again, the main goal of, of a core investor, if you want to invest in these type of investments, it's to generate steady, reliable income with little risk involved. Capital preservation, that's like the key for you if you're this type of investor. And so cash flow is way more important for you than appreciation, right? Or like the increase in value over time. You're not playing for that huge increase. And then you're as an investor, like you're looking to avoid volatility. You like those steady returns. So when it comes to core type properties or type of investments, you can probably expect to receive somewhere between a 6 to maybe even 10% rate of return. Now these type of properties are typically located in like prime markets. These like, you know, higher end cities, they're filled with tenants already and they're pretty much operating at full optimized capacity. Very little active management is necessary because the property is like already considered to be quote, unquote, fully stabilized. And you might see those words pop up quite a bit. And usually people will use a lower amount of leverage or debt. Now there's something called the loan to value ratio, meaning how much of the value of the property are you putting a loan on? Right? And when you do your own residential properties, most people will put, you know, put a down payment of 20% and take a loan for 80%. Now you know, more conservative way to go would be, you know, putting down more and taking less of a loan. Now when it comes to the investment properties, it's the same thing. The less debt you take on, the more conservative you're going to be. Probably lower your returns, but the lower it is, the safer it kind of is for the investor. So for these core type properties, you're typically going to see a lot lower leverage, somewhere like between 65% or below. And so your overall risk in this type of investment is considered very, very low. So an example of this type of investment might be like a fully tenanted like medical office building, long term tenants located in a high demand area. And so you expect steady cash flow from that. As an investor, like, is that something that you're interested in? Does that sound good for you? Like you're looking for a little bit lower risk? Well, not a little bit, but lower risk and lower return. The next type of strategy is the Core plus strategy. Now core plus investors, they're also looking to generate steady returns, but they're willing to take on probably a little bit more risk for potentially slightly higher gains. Remember, a little bit more risk, higher gains. Now, the property might require some slight renovations, but they're still really high quality and they have great tenants in place. Now when you look at these core plus investments in today's market, you could probably expect somewhere between 8 and 12%. Again, these are just general rules of thumb and they change with the market. But core plus properties, they're pretty, again, in pretty good shape. They're in a good market and they might require some slight renovations down the line. Now again, they're filled with great tenants. Some of the leases might be up for renewal, but you know, as a core plus investor, you might see some of these leases up for renewal actually as opportunities to raise some rents, increase income. And usually in this type of case, the amount of leverage again is on the lower side, somewhere between 40 or 50 to about 60, 65%. Now the overall risk, I'd categorize this as as low to moderate. An example of a core investment might be like an older medical building, we're just staying on the medical building kind of line. Might need a little bit of updates, right? You might need some updates. And there are some larger leases that are set to expire soon. Now again, there's some risk there as you can take on as an investor, but again, there's some opportunities to optimize or stabilize the property. Even better, the third strategy is the value add strategy. Now the Goal of the value add investor is maybe to have some cash flow initially or they can delay a little bit of cash flow, but they're really looking for the potential for increased gains and like appreciation through a solid business plan and smart management. So when you look at the business plan of these type of investments, they might include some sort of renovations. I mean, absolutely. I'm sure they will include some renovations where they'll be able to increase rents and what's called the net operating income of the property, like how much it produces. Right, the net operating income. If you're able to increase what's called the net operating income or noi, this is, you know, that's actually one way of forcing appreciation, forcing or increasing the value of the property, like irrespective of the market, right on its own. And that ultimately leads to an increased value of the property. Now, value add investor looks at the upside potential. You see a property and you say, all right, there are, you know, maybe it's not fully occupied. There are some ways to renovate some of the units, increase the value, increase the income, increase the value and probably sell it down the line. Now, there might be some potential for increased cash flow over time, but again, it's not a cash flow machine right off the bat. But definitely there's that upside potential as well. You know, in today's market, a lot of the value add properties, you'll see expected return somewhere between 12 and 18%. So when you look at these type of properties, when you're looking type these type of deals, you're going to, you're going to see these type of words. You're going to see the words value add. You're going to see the words like not operating at full capacity, they may have some vacancies. And, and definitely, again, it's a little bit of a, maybe earlier vintage that could use some renovation. It's going to take some work to get there. Maybe it's going to take a year to initially kind of do a lot of the massive renovation. And when their business plan is executed over time, you can see that massive increase in income and value. Now, the use of leverage and debt in this type of investment is somewhere between medium and high. So you're going to see somewhere between 65 to maybe 80% in terms of leverage and debt. And Talk about the 65 to 80% loan to value is what you might see on these type of investments. Now the overall risk, again, it's moderate to high. So an example of value add investment might be an apartment building. It's probably the most common type that you'll see where they say it's a value add deal, it's a multifamily property, it hasn't been renovated in a while or there are many units that could use some renovations. Maybe the rents are below market. You know, maybe it hasn't been fully managed or managed well. Maybe a long term owner who hasn't done very much over time and maybe currently has somewhere between a 10 to 15% vacancy rate, maybe a little bit lower. But again, there are ways for them to take the business plan and increase rents, maybe drop expenses and do much better and increase the value of the property. All right. And lastly, you know, creeping up the risk chain. The last type of investment strategy is the opportunistic strategy. Now the goal of the opportunistic investor, it's to look for primarily upside potential, right? Significant returns, I'd say a little bit more of the home run play, not fully home, but again, you're trying to hit at least a triple immediate cash flow. It's not the primary concern for you. You know, you're able to see like the bigger vision down the line and see that property as a pathway to like significant gains. I mean, you're content to wait for these returns which might take anywhere from three to to seven years. Now your expected returns in this scenario have to be at least 15% plus, I would say almost these days, about 20% plus. Now these type of deals that fall under the opportunistic category might be things like development deals. You know, in today's environment they always talk about lack of supply in the housing market. So maybe you are investing in development, development of a multifamily development of industrial property, medical office space, something like that. Another type of opportunistic deal that you might see might be a repositioning, what they're called repositioning. Now that means they take a building from one use to another or even it's like a completely empty building or it's a brand new build and they take it and they're going to be putting tenants in it. So let's talk about some examples of that. So there are sometimes there are things like conversions where they take apartment buildings, they convert it to a condo or, or the other way, or maybe a deal is where they just took over a completed development and you as an investor coming in and then you're going to be ramping up that property to be put tenants in and things like that. Now again, there is higher risk there, right? These properties are sometimes in emerging markets, right, opportunistic implies there are potential for higher gains. So, so maybe you're not doing any one of these big markets that's pretty well stabilized, but in like a secondary market that's like, seems to be, you know, on fire. And this kind of thing, the use of leverage or debt is usually, you know, typically on the higher side, they're trying to maximize their returns. And so the overall risk in this type of strategy, I would just call it on the high side, it's completely dependent on good execution and the market can help as well. But again, the potential for gains is much higher. So again, example of this might be some sort of ground up development apartment building that's, you know, that they're building somewhere in one of these markets and you can invest in it. You're not going to see any sort of cash flow, but when they're done and they sell the property, you're going to expect some profits on the backside. So I know when you're looking at these deals, whether it's even for yourself, right, or when you're looking at other type of deals, syndications or maybe these funds talk about what they invest in. They like, how do you actually know what type of investment strategy is involved? Now I think hopefully this podcast will help you kind of narrow that down. You can figure it out from some of the characteristics I mentioned or factors. But another way is to simply ask the operator or sponsor, you know, what type of investment strategy is this? You know, is it a core? A core plus a value add opportunistic, and they should be able to just tell you what the strategy is. You know, I would say that most sponsors, you know, they stick to a certain strategy and they like to kind of sit in that lane. Some of them start to venture out depending on what the market looks like and where the returns kind of seem to be headed. But again, they should be clear on what their strategy is and you should be able to find that sometimes just right in the language of what's called the offering memorandum or deck. They'll mention the type of strategy there. So if you're not sure, don't be afraid to ask because again, you're just trying to align your risk and your returns and trying to figure out what works for you, create a nice diversified portfolio. And I mean, I really believe that, you know, successfully utilizing these strategies and navigating through all this, it really comes from knowing what your risk tolerance is and what your goals are. As some of the things we mentioned, is it capital preservation, you Just don't want to lose money at all costs. Right? Nobody wants that. But is that your main concern? Or do you want just steady cash flow at this point? Or maybe you're at a point in your career, your investing career, where you're just trying to really build up that, you know, your, your net worth and your capital, that nest egg. You're trying to maximize returns right now and you can take a little bit more risk. Maybe you're in the middle where you were looking for a balance. The goal is to really match one of these categories or a mix of these categories to your timeline, your risk tolerance and expected returns. Again, if you've been listening to any of my podcasts, read any of my stuff, I'm a big fan of diversification. Yeah, I think it's extremely important because it gives you some security, right? Knowing that if something goes up, you know, other things may not do as well, or when things don't, don't do as well in one area, other things do better and they kind of smooth out those returns for you. So you can really kind of build your lifestyle according to that and live the way you want to live now. So I diversify when it comes to these strategies, not only by investment strategy, but also location, property type sponsors. You know, some people think I might go a little bit overboard with that stuff, but it helps me sleep well at night. So a good portfolio for you, like a well balanced one, it might contain investments from each category. Right. In different proportions. I mean, again, there's no such thing as perfect portfolio. You know, we get asked that all the time, if you had a hundred K, exactly how would you invest? Or 200 K. You know, opportunities come at different times. The market seems to cycle, and even within these investment strategies, they each might behave differently in different markets. And to be honest with you, trying to time the market is probably not something that you or I going to be completely successful at. There are people who do this all day long and they struggle to time the market. So I think that building that portfolio, that nice diversified portfolio, it's key to kind of, you know, being able to ride through all the waves. And I will tell you, there probably will be a good amount of, you know, there'll be a lot of waves coming up in the next couple years. I think that's something that everyone can agree on. We're not exactly sure how the market's going when, and things will change, but it will change. And so, but it won't change for everything evenly. So making sure you have that good portfolio. It's going to help you sleep at night, it's going to make you feel comfortable as an investor. And ultimately, I believe it'll help you create the life that you want. So take a quick look at your goals, figure out these strategies, understand them, and then figure out what works for you. Okay, I hope that helped. Hopefully it was a nice quick overview for you. When you start using the language of real estate, you start feeling that like an investor, you really step into that identity of somebody who's creating that income outside of medicine, outside of your day job, to create the life that you want. Okay, everyone, have a great week. Let's talk again soon. Enjoy the holidays, enjoy the show. Let me know by dropping a review in the podcast app you're listening to us in. And if you haven't already, make sure to hit subscribe. Are you a part of our community yet? Join thousands of physicians who are also on this journey to creating their ideal lives through multiple streams of income. You can join us on our Facebook group Passive Income Docs, and you can always learn more at our website, passiveincomemd. Com. Thanks again for allowing me to be a part of your journey. See you next time.