Below are four defined categories of property investment based on their respective levels of risk and return. Knowing these four types of investment opportunities will help you to recognize what kind of investor you are and the sort of properties you wish to seek out.
Core: Lowest risk/lowest returns, often purchased to help diversify investments, sought out by conservative investors who want to grow slow and steady.
These property investments are in strong markets such as flourishing urban centers, involve as little leverage (financing through debt, borrowing, or financial instruments such as mortgages, etc.) as possible, and are rented out on a long term basis to especially credit-worthy tenants.
Core Plus: Medium risk/medium returns, still appeals to those who wish to play it on the safe side, but has some chance to increase net operating income with a mild increase in risk.
Similar to Core investments, these properties are located in prosperous areas, have quality tenants, and are easy to finance; however there may be chances to increase returns through an upcoming lease rollover (chance to lose tenant or possibly increase rents and therefore income) or other such instances
Value Add: Higher risk/higher returns, for investors seeking fixer-uppers or who like the challenge of filling properties with higher than average vacancy rates.
They are investments which can be bettered (aka have value added to them) through fixing or improving the physical property and its functions. Such investments are usually bought at discount and resold to core investors. The risk lies in the probability that these properties, once enhanced, will create more cash inflows than it cost to finance and improve them.
Opportunistic: Highest risk/highest return, encompasses all instances in which the investor is willing to take on a large or risky endeavor in order to significantly increase expected returns.
These ventures may include adapting a property for a vastly different function, building a development from scratch, or investing in a high risk or new and volatile market. Such opportunistic investments take enhancement to the next level as the value an investor is adding to may very well be the ground on which they build.
Types of Risk
We see from above that the higher risk taken, the higher greater the potential returns but also the greater the downside. Several specific types of risk are defined here:
Liquidity Risk: How easily can you sell your property for cash, especially if the economy suddenly tips downward, while not having to undersell? The less ability you have to cash out of your investment, the higher the liquidity risk.
Business Risk: Will a change in environment of your property, emerging competition, or a market down-slope greatly hurt your investment? Will the property be well-managed and the value maintained or bettered, or will the project fail altogether?
Systemic Risk: General risk for investors in a nation (or even in international markets) suddenly increases because the dollars true purchasing power from returns is reduced due to war, political change, etc.
Financial Risk: Significant use of debt financing means that in a failure, debt-holders have the ability to call for their back. This can lead to lower or even negative returns. Similarly equity holders can have their rate of return decreased because of an increase in interest rates on short-term or variable-rate loans. General increases in interest rates will likely also lower the purchase price subsequent buyers are willing to pay. This relates to inflation risk.
Inflation Risk: Inflation turns out to be at a higher rate than was accounted for in IRR calculations or in discounted cash flow analysis.
Variance Risk: How likely it is that any of the above risk levels would change and affect the investment negatively?
A better expected rate of return does not make one investment better than another if that investment has significantly higher risk involved. One must research the level of risk each investment has for the various categories, taking into account the possible changes in economy or local market over a period of time, and considering how much should be financed out of debt and how long the holding period should be.