High-Risk / High Returns or Low Risk / Low Returns? There’s a Place for Both in Your CRE Portfolio

High-Risk / High Returns or Low Risk / Low Returns? There’s a Place for Both in Your CRE Portfolio

By Jason Kosena, Chief Acquisitions Officer

In the dynamic world of traditional multifamily syndication, investors have often been pitched opportunities offering project-level Internal Rates of Return (IRR) exceeding 20% accompanied by the promise of instant distributions. This investment avatar, underpinned by the solid foundation of real estate assets, has historically offered a path to rapid wealth accumulation but has also carried a higher risk profile. After all, big returns don’t come risk free! 

However, as today’s economic landscape shifts with rising interest rates and a decline in asset valuations, a different investment world is emerging and some of the risks associated with 20%+ returns are beginning to reveal themselves as the cheap money and compressed cap rate environment of the last 12 years has changed.

At the core of these traditional “value-add” multifamily strategies that aimed for these lofty IRRs are inherent risks, chief among them is the issue of over-leverage. To achieve the projected 20%+ IRRs, sponsors often resort to high levels of borrowing, not just through primary mortgage loans but also through preferential equity, which adds another layer of leverage. 

Such strategies can diminish monthly distributions for common equity investors and place their capital in a vulnerable position, especially if asset values decline.

Another risk stems from the nature of the assets involved. Strategies targeting 20%+ IRRs generally focus on older properties, which carry their own set of operational uncertainties. These include unexpected maintenance costs, bad debt accumulation, and staffing issues, all of which can jeopardize the high, immediate yields promised to investors and challenge the achievement of 20%+ IRRs over the long term.

Additionally, the pressure to add value is a significant aspect of these investment strategies. To fulfill the promise of high IRRs, there’s often a drive to significantly increase Net Operating Income (NOI) over a short period. This urgency can lead to cost-cutting in critical areas such as property maintenance and operating expenses, undermining the quality and sustainability of the investment.

While there is always a place for value-add strategies in every investment portfolio, it’s also wise to hedge those investments with more stable and less risky opportunities, even if they offer lower overall returns. 

In that light, the LBC Wealth Preservation Strategy offers an alternative perspective on real estate investing that is a good fit for today’s economic climate. 

This strategy prioritizes reducing investor risk, ensuring dependable distributions, and providing a more certain overall return. Although it may not target the 20%+ IRR mark, it successfully sidesteps the risks associated with such high-yield strategies, offering investors a more stable and predictable financial journey.

The Wealth Preservation Strategy aims for a more moderate and transparent return profile, targeting an IRR of 10%-12% over a 60-month period, coupled with consistent distributions. It commits to a steady annual yield of 5%-8%, culminating in a strategic property sale in the 60th month to achieve the overall targeted return range.

This approach to risk minimization includes maintaining a maximum 50% Loan-to-Value ratio, which significantly mitigates the impact of rising interest rates and reduces the need for unforeseen capital injections at loan maturity. The strategy also focuses on acquiring newer properties, constructed within the last five years, ensuring greater operational cost stability and adding certainty to distribution projections due to more predictable operating expenses.

By avoiding the pursuit of exciting but also risky 20%+ IRRs, the Wealth Preservation Strategy adheres to simpler business plans that don’t rely on dramatic changes to the asset or its revenue streams to meet investment goals.

While value-add real estate investing has an important place in a balanced CRE portfolio, approaches like the LBC Wealth Preservation Strategy that offer a safer and more predictable pathway to place money into CRE and should be deployed as well. 

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