The Risk-Return Spectrum: Choosing Your Real Estate Investment Strategy
From low-risk turnkey deals to high-return value-add and development—which fits you?
Here’s a question you may be asking yourself: ‘Should I buy a turnkey rental or fixer-upper?’ The answer depends on understanding risk versus return - and knowing where you sit in this spectrum.
Low Risk/Low Return ←――――――――――――→ High Risk/High Return
Last week we discussed the importance of picking a niche in terms of “how” (REIT, LP, solo, GP) and “what”. I introduced the three components of the “what”:
Asset Class: 1-4 unit residential, apartments, office, industrial, retail.
Geography: where you plan to invest.
Strategy: core/turnkey, light rehab, value add (or fix and flip), house hacking.
In today’s discussion, we are going to dive deeper into strategy.
Strategy will likely be the strongest dial you can control to determine the risk and reward that is right for you.
Risk and reward are generally inversely correlated. The more risk you take on, the higher the potential reward.
The key word here is “potential”.
Just because you have the potential to hit a home run, doesn’t mean you will. It often means you have a high chance of not hitting the home run - especially in your early days as an investor.
Successful investors have a clear understanding of risk vs. reward. The best ones pick a risk/reward niche to focus on so they can develop expertise in understanding and minimizing risk, all while trying to achieve above market returns.
Let’s dig in.
Five Strategies for Real Estate Investing
There are five strategies we will discuss today. Four apply to all asset classes. The last one only applies to 1-4 unit residential.
Low Risk/Low Return ←――――――――――――→ High Risk/High Return
Core/Turnkey → Light Rehab → Value Add → Development
Core/Turnkey: low risk, low return. You buy a property that is well leased and maintained. There is minimal work to do.
Light Rehab: medium risk, medium return. There is some work to do, but it is mainly cosmetic (paint, carpet, clean up). If you do the work, you can increase the rent and value of the property.
Value Add: high risk, high return. There is a lot of work to do. The property might even be vacant. You will be repositioning it and taking on a lot of risk for superior returns. You will either find a tenant once the work is complete or sell it (fix and flip).
Development: highest risk, highest return. You build something from scratch.
House Hacking: this option only applies to 1-4 residential. You will live in one unit (or room) of the property and rent out the other units (or rooms), allowing you to live rent free or at a reduced cost.
Each strategy has its own pros and cons. There is no right answer.
Choosing the right one for you depends on the time you have and your tolerance for risk.
Let’s discuss each one in more detail.
Core/Turnkey: Low Risk, Low Return
These type of deals require minimal work. They are fully leased and the physical building is in good condition. They are closest to stock market index fund investing in effort (low) and function similar to a bond, giving you consistent cash flow. Examples could include:
A single tenant leased building built in the last 10 years and leased for 10+ years. This could be retail, industrial, or even office.
A new four-plex in a strong housing market near a hospital or other major employer. Although the leases are not long, there is a major employer nearby who helps ensure all units will remain leased with little downtime between leases.
Core/Turnkey deals are great for investors that want steady cash flow and don’t have a lot of time.
Light Rehab: Medium Risk, Medium Return
Let’s continue up the risk/return spectrum to Light Rehab. There is some rehab to do, but it is fairly straightforward and mainly cosmetic (paint, carpet, clean up). It is the type of work that you could potentially do yourself on nights and weekends, or hire a handyman to do.
Essentially, you are freshening up the property and once complete, will enjoy some combination of higher rent, shorter time between leases, better credit tenants, or a combination of all three. Examples could include:
A well built four-plex that is 30+ years old in a good market. The paint is peeling and the carpets are stained. Both are straightforward to fix. Buildings that look cleaner and more appealing are leasing for 10%+ more rent than the in place leases at this property.
A single tenant industrial building that only has six months left on the lease. The existing tenant has been there for 10+ years, plans to vacate, and is leaving the space very dirty. Painting the walls, replacing the carpet in the office, and power washing the warehouse floors will make it look much better.
Light Rehab deals are good for investors that want to be a little more hands on in order to achieve better returns than core/turnkey. They are ok with some risk, but are not willing to spend too much additional money nor take on something too complicated.
Value Add: High Risk, High Return
Let’s continue up the risk/return spectrum. By buying a value add deal, you are signing up for a hands on investment. There will be a lot of work to do, including work that is not just cosmetic in nature. You may be redoing bathrooms or replacing roofs or even building out new rooms.
This is much more than a light freshen up. It will likely include hiring a general contractor and obtaining a building permit. All of this means more time and money.
In exchange, you will enjoy a meaningful increase (ex. 25%+) in the value of the property through a combination of higher rent, shorter time between leases, better credit tenants, or a combination of all three. Examples could include:
A 40+ year old two story home in a zoning location that allows for up to four units. The investor will convert the property into a four plex. This will include adding three small kitchens and a new restroom, plus reconfiguring the property to create four individual private entrances.
A 20+ year old retail property that had been leased to one tenant since it was built. The investor will convert it to a three tenant building by adding demising walls, bathrooms, and storefront entrances.
Value Add deals are good for investors that have a vision for what a property could be. They have time and money to do the work and are determined to maximize the value of their investments.
Development: Highest Risk, Highest Return
Developers are a breed of their own. They are like business entrepreneurs who create something out of nothing. Development is so complicated that I could (and may) dedicate an entire newsletter to it.
For now, let’s just say that it includes (i) buying the land with a vision for what could be built, (ii) creating an initial design and getting municipal approval to build it - the entitlements, (iii) spending time and money on construction drawings, (iv) going back to the municipality for a building permit, (v) hiring a general contractor to build the property, and (vi) leasing it. Examples could include:
Buying vacant land and building a small industrial building.
Tearing down an old house and building a new four-plex.
Development is a high risk process at each step. It is not for the faint of heart or inexperienced. Each step requires specialized knowledge: architecture, engineering, municipal approvals, construction management, and market analysis. Most developers spend years learning their craft before attempting their first project.
House Hacking: 1-4 Unit Residential Only
House hacking is a way to satisfy your own housing needs and be a real estate investor. You buy a property to live in that is bigger than you need and rent out the rest, allowing you to live rent free or at a reduced cost. Here are two examples:
You buy a four-bedroom house with one kitchen and 3-4 bathrooms. You live in the master bedroom with a private bathroom and rent out the other rooms. You all share the living room, kitchen, and laundry room. Maybe you rent the rooms to friends as you will be sharing a lot of space together.
You buy a duplex. You live in one unit and rent out the other. Your tenant lives in their own unit. There is no shared space.
House hacking is a creative way to become a real estate investor. Lenders view 1-4 unit residential as personal home loans, which can be easier to qualify for if you are a first time investor.
However, you have to be comfortable living with or near your tenants. This can get messy, especially if living with friends. Example: your buddy loses his job and can’t pay the rent. Are you willing to kick him out? Just plan ahead for what you are willing and not willing to do.
Understanding Strategy
Now that we have discussed five strategies, let’s break down the characteristics that (a) determine the risk associated with an investment and (b) determine your fit for each strategy.
Risk Associated with an Investment
To oversimplify, there are four main risks associated with a real estate investment:
Occupancy: is the property leased? How soon do the leases expire?
Rent vs Market: are the existing tenants paying market rent? Is there an opportunity to increase the rent? What are the current and anticipated market conditions?
Property Condition: is the property old? Is there deferred maintenance? Are the units leasable as is or do they need to be cleaned up first?
Property Function: is the property functional as configured? Do the number of units needed to be increased or decreased?
Let’s combine these with the first three strategies (excluding development and house hacking):
Core/Turnkey: Low risk, Low return.
Occupied
Rent at or Near Market
Good Property Condition and Function
Light Rehab: Medium Risk, Medium Return.
Vacant or Occupied Short Term
Rent Below Market
Property Condition Can Be Improved
Property Functional As Is
Value Add: High Risk, High Return.
Vacant or Occupied Short Term
Rent Below Market
Property Condition and Property Function Can Be Improved
Your Fit for Each Strategy
Now let’s add in what is required for each relative to how it will impact you as an investor from a time and future dollar commitment standpoint.
Core/Turnkey: Low risk, Low return.
Most passive; minimal time commitment and ongoing capital investment.
Light Rehab: Medium Risk, Medium Return.
Active for focused periods of time; more passive after rehab; requires some investment of dollars and time after purchase.
Value Add: High Risk, High Return.
Very active for focused, extended periods of time; may be more passive after rehab; requires significant investment of dollars and time after purchase.
Development: Highest Risk, Highest Return.
Significantly time consuming for 2-3+ years; requires coordinating the efforts of many consultants and specialists; material capital commitment years before completion.
Very Important Side Note: Strategy is only one element of a real estate investment. The market you invest in will play a HUGE role in the success of the deal. Spend the time to research and understand the market before you make your first investment. Talk with brokers. Read research papers. Understand the major employers and drivers of the local economy.
My Strategy Evolution
Here’s how it evolved for me over the past 23 years of investing.
Stage I - Clueless to Strategy: I made an LP investment in a value add hotel deal. I had no idea there were different types of strategy or that I was taking on more risk than I realized. I was lucky it worked out.
Stage II - Value Add with Employer: I spent most of my career with a GP focused on value add industrial. By joining an established firm with leaders who understood value add investing, I was able to get paid to learn. When I made personal investments, it was mainly alongside seasoned investors who had “been there, done that”.
Stage III - Value Add as LP: In 2015, I started making LP investments with a multifamily GP focused on value add deals. I even spent two years working for the GP and learned the operational side of the multifamily business. Their leadership team had years of value add investing experience. They were able to minimize risk through their extensive track record.
Finding the Strategy That Fits You
So which is right for you?
If you are new to real estate investing, you don’t know what you don’t know.
Something that may look risk-free to you could be riskier than you think. Something that looks risky to you, could appear much less risky to a seasoned investor.
Unless you can work for an experienced GP and invest alongside them, I recommend starting simple with a core/turnkey or light rehab.
Get a few deals under your belt.
Make some mistakes and learn from them before you buy a value add deal.
Here’s a quick self-assessment guide. Ask yourself:
Time: Do I have time on evenings/weekends for 3-6 months?
If not, then consider a Core/Turnkey deal.
Capital: Can I set aside cash reserves for cost overruns and unexpected issues?
If not, then consider a Core/Turnkey or Light Rehab deal.
Experience: Have I completed 2+ deals through stabilization and/or sale?
If not, then consider starting with a Core/Turnkey or Light Rehab deal.
Tolerance: Can I sleep at night with a property that is filled with uncertainty?
If not, avoid Value Add and Development.
Be honest with yourself. Miscalculating risk and how you will handle it can turn your side hustle into a 20-40 hour per week commitment.
Investing takes time and patience.
You can always become a value add investor later down the road. Just recognize that you need to put in your reps with simpler deals first.
Learn the fundamentals of operating real estate: market analysis, the acquisition process, securing a loan, executing a business plan, property management, tenant relations, and property accounting.
Doing this on a simple, low-risk deal really has its benefit.
There are no shortcuts.
You have to put in the work.
Professor Bateman