The 4 Generic Real Estate Investment Strategies Categories
The execution of a great real estate investment strategy can differentiate between a fruitful business and a dead business. The same can be said for real estate investments. To continue growing your wealth and your prowess as a real estate investor, you should understand universal real estate investment strategies.
You can benefit heavily from understanding and implementing sound real estate investment strategies. Contrary to many other assets, investors have direct control of your real estate project’s performance leading to many other benefits and superior investment returns.
Each of the following strategies can be segmented further by adjusting your entrance strategy, exit strategy, management plan, or financing approach. However, formulating your specific project plans should wait until you fully comprehend the four generic real estate investment strategies. Understanding these strategy categories will lead you to the answers you will need throughout the life of your investment. These approaches will determine whether a project should be in your investment portfolio based on the risk involved or the profit potential. It will help you fairly compare investment opportunities too and avoid comparing apples and oranges.
Two Criteria to Determine Real Estate Investment Strategies
You only need to ask yourself two questions to determine your broad real estate investment strategy. First, are you looking to invest for the long term or do you want to maximize your returns in a few years? The second question you must ask yourself is whether you plan to make improvements and bring change to the property.
If you are a long-term investor who brings minimal change to a property, that qualifies under the buy & hold strategy. For a minimally changing shorter-term investment, recapitalization is a strategy that works well as both a generic strategy and an exit strategy.
Long-term property change is considered real estate development and short-term changes are called value-add or repositioning.
| Long-Term | FAST TURNAROUND | |
|---|---|---|
| PASSIVE | Buy & Hold | Recapitalization |
| ACTIVE | Development | Repositioning |
Buy & Hold Strategies
While each class of real estate has its different techniques and abilities, the buy-and-hold strategy is by far the most common. While this strategy still requires skill and knowledge to be successful, it could be argued that it is simpler than others, leading to its popularity.
To successfully utilize this type of strategy, you must buy a real estate property for a great price. By acting in desperation, you can overpay and jeopardize the entire strategy. But when done correctly, the asset generates revenues allowing you to pay off expenses and debt over time. Through this manner, you can have a stream of passive positive cash flow to use to reinvest or improve your quality of life.
An example of a buy-and-hold strategy is purchasing a small retail strip with long-term tenants that continue to pay lease revenue as you age. When you reach retirement age, you can continue to receive your regular income stream or sell your portfolio for a large retirement nest egg through the equity you have built.
Recapitalization Strategies
The “recapitalization” real estate investment strategy could be considered the same as a refinance or a restructuring. Essentially, this approach involves changing the capital structure of a building to improve the property finances. This can be done through the common method of refinancing or through an equity partner.
Those of you with a higher level of real estate knowledge will understand that both equity partnerships and refinancing are exit strategies. However, for investment managers here at Eikon Investment Group or elsewhere, following through with a recapitalization on a property we already have a say in allows us to switch clients or portfolios. For example, if we held a 48-unit multifamily property that used 70% debt on the property. Changing market conditions may change that now hurt that property. Since we still love that property and believe in it, instead of dumping it completely, we can undergo a recapitalization and minimize the debt ratio from 70 percent to 40 percent. Afterward, we move the property from the portfolios of our risk-tolerant clients seeking a high return to our more risk-averse clients. With the new influx of capital, the higher-risk portfolio can then find a more suitable property for the returns and risk that those investors desire. In this scenario, everybody wins. The risk-tolerant investors can own a new deal, the risk-averse clients receive a great investment that they are comfortable with, and we get to make all our investors happy by servicing their needs.
Although this is becoming increasingly rare, another scenario where recapitalization is more than just an exit strategy is when purchasing a property with assumable debt. Most debt obligations are non-assumable. However, some types of loans will pass on to you as the new owner. When this happens, the recapitalization strategy will require you to work out obligations with the lender. If you want to avoid this, you should understand the types of common liabilities.
Repositioning Strategies
Repositioning is a strategy that can create significant returns in a relatively short time frame by changing where the property fits into the marketplace. The repositioning strategy allows for significant change to the physical appearance of the property, asset operations, or changing the deals with the tenants of your asset to minimize competition. This is a tactic that allows for a lot of creativity in the management and business plan of your real estate project. A well-crafted plan and deliberate execution create the potential for immense returns.
The more common version of repositioning that most people have heard of is real estate flipping, which is buying, improving, and selling over a short period, almost always a few months or less. In commercial properties that have tenants with leases, the value-add strategy involves seeking fast ways to improve the building operations, cut expenses, or improve the value and raise the rents. A value-add project will likely take over a year to resign tenants at new rates.
Although the terminology of “value-add” suggests always adding value, sometimes the best way to add value is by subtracting it. For example, imagine an apartment complex where 3 tenants with larger units pay $1900 per month. By rehabbing this section of the building, you can add 2 units by making all of them smaller. Now the market rent for these 5 units is $1450 per month. Even though these units will rent for less, you will make more. You increased your annual revenue by $15,600, causing the property to appreciate by $195 thousand (based on an 8% cap rate) while also decreasing the vacancy risk on the property which could improve your asset value and cash flow even further. The beauty of this real estate investment strategy is that the sky is the limit if you creatively execute a brilliant strategy based on sound market research.
Development Strategies
The long-term improvements strategy is known as ground-up development or property development. This real estate investment strategy consists of constructing a building that will generate future cash flows. Development as a strategy requires patience and creativity to succeed. Considering the grandiose planning and market research that is required, not many individuals try to tackle this strategy leaving it to investment firms. Projects that include this strategy can have negative cash flow in the beginning years of the plan. Hence, tactical financial management and maintaining solvency will be key.
With property development, the vast number of choices that occur over the project life drastically increase the potential for returns. In general, the more value you can add to a property the higher the payoff. On development projects, you add all the value besides the location. One of the main keys to a successful development project is to build your project for less than the market value. This means that when a market is trending upwards this is one of the most profitable investments, which is why we often see large complexes being built up during this part of the market cycle. During the expansion of the market, the market value can easily exceed the replacement cost, the price that you would pay to replace an existing building with a substitute.
When you as a real estate developer use the development strategy most effectively, you can mix and match it with other strategies. Take one piece of land in a prime spot. The investor can initiate construction with the long-term goal of holding to build equity. After the initial debt, the investor can recapitalize take capital gains and move it to a less ambitious portfolio. Just remember the two biggest keys to this strategy of patience and creativity.
Real Estate Investment Strategies Ranked
Of the four generic categories of real estate investment strategies, each has its pros and cons. Strategies vary in their potential risk, returns, and activity levels, although risk, returns, and activity generally correlates. When activity is high, more things can go wrong which brings more risk, but more value can be added which can boost returns. A development strategy will require the most work, carry the most risk, but generally, have the highest returns. Following is the repositioning strategy and third, comes the buy & hold strategy. The flexibility of a recapitalization strategy certainly makes it an outlier for this ranking list but will usually carry the least risk if another strategy was implemented successfully first.
The Strategy Investors Should Implement
The strategy you implement is dependent on an excess number of factors. The economic cycle, the real estate market cycle, interest rates, tax policy, which real estate assets are hot, inflation, and consumer confidence will all play a tremendous role in which real estate investment strategies prosper and falter. Those are just the factors that other people control. Additionally, you will need to consider the factors in your personal life such as your income, your financial goals, retirement planning, how you prefer to spend your free time, as well as your family and relationship status. Taking all of this into account real estate investing can seem overwhelming or more trouble than it is worth. However, the benefits of real estate investing far outweigh the drawbacks and that is why it has been America’s most traveled path to wealth since our founding as a nation.
Real estate investing should be wholly customized to the personal and economic circumstances that will impact your investment. For investing help, you can always reach out to us at invest@eikoninvestments.com.
Happy Growth.
