Investing in Real Estate Private Equity can be a great solution to quickly invest in all types of commercial real estate from multi-family apartment complexes to medical, office, self-storage and of course, non-commercial single-family houses while letting someone else handle all the details.
This post is a continuation in the series on Investing in Real Estate Private Equity, a guide to Real Estate Partnerships, Real Estate Private Equity Funds, Syndicates & Crowdfunding. In our last post, Using Location to Diversify Your Real Estate Investments, we discussed the different real estate economic cycles and how the different commercial real estate asset classes perform during each phase. Here we are going to dig deeper into the different development stages of real estate and specifically the advantages, disadvantages and risks associated with each stage.
Building Dreams: Understanding the Stages of Real Estate Development
Real estate deals can be classified into several development stages based on the level of risk and potential returns they offer. The three main stages of real estate deals are ground-up construction, value-add, and core, with core deals being the least risky but offering lower potential returns. Core-plus and opportunistic deals are subcategories of value-add deals, offering some potential for value creation with varying levels of risk.
Let’s dig into each of these development stages and discuss the advantages, disadvantages and risk associated with each one.
Building from Scratch
This type of real estate deal involves developing a property from scratch, including acquiring the land, designing and planning the project, obtaining necessary permits and approvals, and constructing the building. As a result of all the moving parts, ground-up construction deals typically involve significant risk but can offer higher potential returns.
I would only invest in a group-up deal if the sponsor was very experienced and has proof that they have done buildouts many, many times in the past. Just like doing construction on your home, there are just to many things that can go wrong during the process that can make the deal much riskier. With this said, these are the types of deals that you read about, where big money can be made. So, you are definitely on the high risk / high (potential) reward end of the spectrum.
- Full control over design and construction
- Potential for higher returns due to lower cost basis
- Ability to customize the property to meet market demand
- High upfront costs and longer development timeline
- Higher risk due to unknown variables in construction and market demand
- Construction risk unexpected costs, delays, and quality issues can arise during the construction process.
- Market risk market conditions can change during the construction process, affecting demand and pricing for the completed property.
- Financing risk financing for ground-up construction can be difficult to obtain, and if financing falls through, the project may be cancelled.
To summarize: Ground-up construction offers full control over design and construction, but it comes with higher upfront costs and a longer development timeline.
Value-Add Real Estate Development
Value-add deals involve purchasing an existing property that is in need of renovation or repositioning to increase its value. This type of real estate deal typically involves identifying properties with untapped potential, executing a renovation or repositioning plan, and then either selling the property or holding it for rental income.
The premise of Value-Add is to buy the worst property on the block (at a discount), then remodel it to bring it up to the neighborhood values, and either raise rent, fill up all the vacancies, or sell now that you have added value.
- Opportunity to purchase properties at a discount
- Potential for higher returns due to increase in property value
- Ability to create value through renovation or repositioning
- Execution risk – renovation or repositioning plans may not go as planned
- Market risk – market conditions can change, affecting demand and pricing for the renovated or repositioned property.
- Financing risk – financing for the purchase and renovation can be difficult to obtain, and if financing falls through, the project may be cancelled.
To summarize: Value-add deals offer the opportunity to create value through renovation or repositioning, but execution risk and market risk can be a disadvantage.
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Investing in Stability
Core Real Estate Development
Core deals involve investing in stabilized, income-producing properties that are considered low risk. These are properties that are generally in good condition, fully leased and you are taking over with little price discount.
The goal is to buy a good income producing properties and enjoy it’s rental income. Of course, the secondary goal is always to hope the property appreciates that can add value at the time of sale. These properties typically have long-term leases with reliable tenants and provide consistent rental income. Core deals offer lower potential returns but also lower risk.
- Lower risk due to stable, income-producing properties
- Consistent rental income
- Long-term leases with reliable tenants
- Lower potential returns compared to other types of deals
- Limited potential for value creation
- Market risk market conditions can change, affecting demand and rental rates for the property.
- Tenant risk if a tenant defaults on their lease, it can affect the property’s cash flow.
- Maintenance risk maintenance and repairs are ongoing expenses that can impact the property’s value.
To summarize: Core deals are considered low-risk investments with stable, income-producing properties, but they offer limited potential for value creation.
Balancing Risk and Reward
Core Plus Real Estate Development
Core-plus deals involve investing in properties that are considered low risk but have some potential for value-add opportunities. These properties may have some vacancy or underutilized space that can be leased up or repositioned to increase value. This is sort of a combination of the Core and Value-add categories above.
- Potential for value creation through leasing or repositioning
- Less risk than value-add or opportunistic deals
- Still considered low-risk investments
- Lower potential returns compared to value-add or opportunistic deals
- May not offer as much value creation potential as other types of deals
- Execution risk execution of the leasing or repositioning plan may not go as planned, resulting in lower returns or even losses.
- Market risk market conditions can change, affecting demand and pricing for the renovated or repositioned property.
- Tenant risk if a tenant defaults on their lease, it can affect the property’s cash flow.
To summarize: Core-plus deals have some potential for value creation but offer lower potential returns compared to value-add or opportunistic deals.
Opportunistic Real Estate Development
Opportunistic deals involve investing in properties or markets that are experiencing significant changes or disruption, such as distressed properties or emerging markets. This type of real estate deal typically involves higher risk but also offers the potential for higher returns.
Opportunistic deals are usually oriented around specific market disruptions. A good example of this occurred after the financial crises of 2008. There were tens of thousands of properties that were foreclosed on. And, banks were looking to unload huge inventories all at once. Allowing investors to buy blocks of homes in one deal sold at super cheap pricing. This presents a huge profit opportunity IF the market recovers and you can wait it out.
Another good example is after weather events like a hurricane. Being able to purchase properties for ten cents on the dollar, with the huge risk of not knowing if there is damage inside or whether the neighborhood will ever recover to its previous state.
- Potential for high returns due to low entry cost and high value creation potential
- Ability to capitalize on market disruption
- Ability to purchase distressed properties at a discount
- High risk due to market uncertainty if the market does not turn in the desired direction, resulting in lower returns or even losses.
- High risk due to execution risk. Execution of the value creation plan may not go as planned, resulting in lower returns or even losses.
- Potential for significant losses if the market or execution does not go as planned
- Financing risk financing for opportunistic deals can be difficult to obtain, and if financing falls through, the project may be cancelled.
To summarize: Opportunistic deals offer the potential for high returns due to low entry cost and high value creation potential, but they also come with high risk due to market uncertainty and execution risk.
In summary, real estate development stages each has its good and bad, but much like investing in general, there really is no right or wrong type of real estate deal. The type of real estate deal an investor chooses will depend on their risk tolerance and investment goals. But, each should be carefully weighed based on its own unique advantages and disadvantages, as well as risks, and it’s essential to carefully consider these factors before making an investment decision. You will find a certain type of deal that just feels right with you.
In our next post, we will discuss the two types of real estate deal structure and specifically, debt vs equity real estate deals.
Share your thoughts below on Real Estate Development Stages? Which is your favorite to invest in?
Keep reading to learn more about: Investing in Real Estate Private Equity
- Why You Need Real Estate Private Equity, The Ultimate Guide
- What is Real Estate Crowdfunding? Everything You Need to Know.
- What Types of Real Estate Can You Invest In? How to Lower Risk with Real Estate
- Real Estate Asset Classes: Everything You Need To Know To Reduce Risk In Your Portfolio
- Real Estate Economic Cycles: Know When To Invest
- How to Diversify Your Real Estate Investments
- Real Estate Development Stages: You Need To Know This
- Real Estate Equity vs Debt: You Need to Know The Difference
- Real Estate Private Equity Advantages: A Need To Know Guide
- Real Estate Private Equity Disadvantages: Everything You Need To Know
- Real Estate Syndication vs REIT: How to Passively Invest in Real Estate
- Unlocking the Mystery: Pari Passu in Real Estate Investments