Introduction
Private real estate is commonly divided into four strategies: core, core-plus, value-add, and opportunistic, which includes development. This guide describes each one by what it buys, how its returns arise and how it can lose money. It then compares the four, works through how leverage changes the effect of a fall in value, and describes how the strategies are structured and held in Canada.
What separates the strategies
A property produces two kinds of return. The first is income: rent, less operating costs, paid out while the property is held. The second is the change in the property's value between purchase and sale. The four strategies differ mainly in how much of the expected return depends on the second, and in particular on the sponsor changing the property in some way.
At one end, core buys a building that is already leased and operating, and most of the return is the rent it already earns. At the other, development buys land or a building to be replaced, and the return depends almost entirely on what the finished property is worth. In between, core-plus and value-add buy properties that need progressively more work.
Three things tend to rise along the spectrum together:
- Dependence on execution. The more of the return that comes from a business plan, the more the result depends on the sponsor carrying it out on budget and on time.
- Leverage. Strategies that rely on a plan are commonly financed with more debt, often short-term or floating-rate loans that must be repaid or refinanced when the plan is complete.
- Exposure to timing. A plan that ends in a sale or a refinancing depends on market conditions at that moment, which the sponsor does not control.
The spectrum describes where risk comes from. It does not mean that the lower-risk strategies cannot lose money. All four can, for different reasons, and the sections below describe how.
Core
What it buys
Core buys stabilized, income-producing property: buildings that are substantially leased, in established locations, with tenants on leases that run for years. A fully leased apartment building in a large city, a grocery-anchored shopping centre, or an industrial warehouse leased to an established tenant are the kinds of property the label is commonly applied to. Leverage is low.
How returns arise
Most of a core property's return is the rent it already collects. The property is held mainly for that income, which is why core is often compared with fixed income. Its value still moves. Commercial property is commonly valued by dividing its net operating income by a capitalization rate, the yield buyers are prepared to accept. When income grows, value tends to grow with it.
How it loses money
- Rising capitalization rates. When interest rates rise, buyers generally demand a higher yield from property, and the same income supports a lower value. A core property can fall in value with no change in its rent or its tenants. The worked example below shows the arithmetic.
- Tenant concentration. Core portfolios often hold fewer, larger properties, and some depend on a small number of tenants. A large tenant leaving, or failing, removes a meaningful share of income at once.
- Fixed rents in inflation. Long leases at fixed rents protect income when markets weaken, but in a period of high inflation the rent can lag the costs of owning the building.
- A change in demand for the property type. What counts as core depends on what tenants want. A property type that is stable in one decade can lose that standing in the next. Downtown office buildings, after the spread of remote and hybrid work, are the widely cited case.
- Liquidity in open-end vehicles. Much core real estate is held through open-end funds and trusts that let investors redeem periodically. When many investors ask to redeem at the same time, those vehicles commonly limit or suspend redemptions, and capital stays invested longer than expected.
One published index shows the pattern. In the United States, the NCREIF Fund Index of open-end diversified core equity funds (NFI-ODCE) reported a total return of −12.14%, gross of fees, for the year ended September 30, 2023: an income return of 3.46% and an appreciation return of −15.19%, which NCREIF described as the largest negative appreciation since the global financial crisis. Over the same year, distributions and redemptions paid from those funds were more than twice the new contributions (NCREIF, NFI-ODCE third-quarter 2023 press release, October 30, 2023). Income was still positive. The loss came from the fall in value.
Core-plus
What it buys
Core-plus buys property that is broadly stabilized but has something to improve: leases below market rent that will expire and can be renewed at higher rents, some vacancy to fill, or modest renovation such as common areas and building systems. Leverage is commonly somewhat higher than in core.
How returns arise
Income is still the larger part of the return. The "plus" is the increase in income the sponsor expects to add through leasing, light improvements and management, and the higher value that income supports.
How it loses money
Core-plus carries everything that can go wrong in core, and adds two things.
- Execution. The higher rents or the lease-up may not happen. Expiring leases may renew at lower rents than planned, or tenants may leave.
- Leverage. More debt means the equity absorbs a larger share of any fall in value. The worked example below shows that the same fall in value costs the equity more as debt rises. If values fall far enough, the equity can be partly or wholly lost, and a loan that comes due may not refinance at the same amount.
A core-plus investment that does not achieve its plan does not simply earn a core return instead. Because its income depends partly on the plan and its equity is more leveraged, it can lose capital.
Value-add
What it buys
Value-add buys property with a problem the sponsor believes it can fix:
- Physical condition: renovating suites, upgrading building systems or modernizing an older office or retail property.
- Operations: replacing poor management, reducing costs or improving the tenant mix.
- Vacancy: buying a substantially vacant property and leasing it up.
- Positioning: changing the tenants or the market a property serves.
How returns arise
The sponsor buys at a price that reflects the problem, carries out the plan, and expects the property's net operating income to rise once the work is done. Because value is commonly set by dividing income by a capitalization rate, higher income supports a higher value. The return comes mainly from that gain, realized on a sale or captured through a refinancing. Income is often low while the work is under way, because suites or space are empty during renovation.
How it loses money
- Cost overruns. Renovations can cost more than budgeted, particularly when construction costs are rising. The contingency in the budget may not cover them.
- Delays. Permits, construction and leasing can all take longer than planned. Each month of delay adds interest and holding costs while income stays low.
- Rents not achieved. The plan assumes that renovated space leases at a higher rent. If the market does not pay it, the income that justified the cost does not arrive.
- Exit value. The plan assumes a capitalization rate at sale. If rates in the market are higher when the property is sold, the sale price is lower for the same income.
- Short-term debt. Value-add is commonly financed with bridge loans, often at floating rates, that are meant to be repaid by a refinancing or a sale once the property is stabilized. Rising rates increase the cost of the loan during the work, and lower values can leave the new loan smaller than the one it replaces. The difference has to be found from new equity, a sale or a lender's forbearance.
When these risks combine, the outcome is a loss of capital, not a lower return.
Opportunistic and development
What it buys
Opportunistic is the broadest category. It includes:
- Ground-up development: building a new property from land.
- Major redevelopment: gutting a building or changing its use, for example converting office space to residential.
- Distressed acquisitions: buying from forced sellers, from lenders after a foreclosure, or out of insolvency proceedings.
- Complex situations: transactions that turn on a legal, financing or ownership problem.
How returns arise
In development, the return is the difference between what the finished, leased or sold property is worth and what it cost to acquire the land, obtain approvals and build. There is no income during construction, and interest and other costs accrue throughout, so the whole return depends on the outcome at the end. In distressed acquisitions, the return depends on having bought below what the property is worth once the problem is resolved.
A development project passes through four stages, and each introduces its own risk:
- Acquiring the land or building.
- Obtaining approvals: zoning, site plans and permits.
- Construction.
- Leasing, or selling the completed units.
How it loses money
- Approvals. Municipal approvals can take years and may not be granted, or may be granted on terms that change the project. Land bought for a project that cannot proceed may be worth much less than was paid.
- Construction costs. Materials, labour and contractor failures can push costs above budget. The construction contract decides who bears that: a fixed or guaranteed maximum price moves some of the risk to the builder; a cost-plus contract leaves it with the owner.
- Market change during construction. A project can take years from land to completion. Rents, sale prices or demand for that property type can change in the meantime.
- Interest rates. Construction loans are commonly floating-rate. A project budgeted when rates were low can stop working if they rise during construction.
- Pre-sales. Projects financed partly on the strength of pre-sold units depend on those buyers completing their purchases when the building is finished. If prices have fallen, some may not.
- The capital stack. Construction lenders, and any mezzanine lender, are repaid before the equity. Cost overruns and shortfalls fall first on the equity.
- Further capital. Development often needs more equity than first raised. A limited partner that does not meet a capital call can face significant penalties under the partnership agreement, including dilution.
Outcomes in this category range widely, from large gains to the loss of all the equity. Projections are commonly prepared on the assumption that the project proceeds as planned, so the sponsor's record on comparable projects, including the ones that went wrong, carries particular weight.
The four strategies compared
| Core | Core-plus | Value-add | Opportunistic and development | |
|---|---|---|---|---|
| What is bought | Stabilized, leased property | Broadly stabilized property with something to improve | Property with a fixable problem | Land, redevelopment, distressed property |
| Main source of return | Rent already contracted | Rent, plus added income | Gain from carrying out the plan | Gain on completion, sale or recovery |
| Income while held | Most of the return | Most of the return | Often low during the work | Usually none until completion |
| Leverage | Low | Moderate | Moderate to high, often short-term | High, often construction loans |
| Main ways it loses money | Rising capitalization rates, tenant loss, change in demand | Plan not achieved, leverage | Overruns, delays, rents, exit value, refinancing | Approvals, costs, market change, rates, capital stack |
Losses are possible in every column. What changes from left to right is how many things have to go right, and how much debt sits ahead of the equity when they do not.
Worked example: one fall in value at three levels of debt
This example is hypothetical. It uses round numbers and describes no property, sponsor or year. It ignores income, fees, transaction costs and loan repayments so that only the effect of leverage shows. The three levels of debt are chosen to illustrate the mechanism; they are not conventions for any strategy.
Step 1: why the value falls. A property earns net operating income of 6 a year. Buyers value it at a capitalization rate of 6%, so it is worth 100 (6 ÷ 0.06). Interest rates rise, and buyers now require a capitalization rate of 7.5%. The same income of 6 now supports a value of 80 (6 ÷ 0.075). The rent has not changed; the value has fallen by 20%.
Step 2: what the fall does to the equity. Three owners bought the same property for 100 with different amounts of debt. The debt is still owed in full after the fall, so the whole loss of 20 falls on the equity.
| Debt at purchase | Equity at purchase | Equity after the fall | Change in equity | Debt as a share of new value |
|---|---|---|---|---|
| 30 | 70 | 50 | −20 ÷ 70 = about −29% | 30 ÷ 80 = about 38% |
| 55 | 45 | 25 | −20 ÷ 45 = about −44% | 55 ÷ 80 = about 69% |
| 70 | 30 | 10 | −20 ÷ 30 = about −67% | 70 ÷ 80 = about 88% |
Step 3: what happens when the loan comes due. Assume a new lender will lend up to 65% of the property's current value. At a value of 80, that is 52 (80 × 0.65).
- The owner with 30 of debt refinances without difficulty.
- The owner with 55 of debt can borrow only 52, and has to find 3 from new equity or a sale.
- The owner with 70 of debt can borrow only 52, and has to find 18: more than the 10 of equity it has left.
The arithmetic runs the same way in reverse. A 20% rise in value adds 20 to each owner's equity: about 29%, 44% and 67% respectively. Leverage magnifies gains and losses alike, but a loss also arrives with a refinancing problem, which a gain does not. A rise in capitalization rates that a low-leverage core property can carry through to the next valuation can force a highly leveraged value-add or development project to raise capital or sell.
Labels and what sits behind them
The four labels are conventions, not regulated categories. There is no standard that decides when a property stops being core-plus and becomes value-add, and sponsors apply the labels with some latitude.
- A core-plus fund may buy a property that needs more work than its label suggests.
- A value-add business plan may be described as opportunistic, which can support higher fees or a larger share of profits for the sponsor.
- A development project changes category as it progresses: opportunistic during construction, closer to core-plus or core once it is built and leased.
For these reasons, diligence practice treats the business plan, its assumptions and what happens if they fail, rather than the label, as the subject of review.
How the strategies are held in Canada
The strategies tend to sit in different vehicles, because each vehicle's structure fits some plans better than others.
- Open-end vehicles, often structured as private real estate investment trusts, have no fixed end date. Investors subscribe and redeem periodically, at a unit value based on appraisals, subject to limits the vehicle sets. Funding redemptions requires stable, valued property and cash or credit to pay out, so these vehicles hold mostly core and core-plus property and less property under development.
- Closed-end limited partnerships and funds have a defined term. The general partner calls capital as it is needed, carries out the plan and sells. A fixed end date suits a plan with a beginning and an end, so most value-add and opportunistic investment is held this way.
- Single-property syndications raise capital for one property or project. The investor's outcome depends entirely on that property and that sponsor.
Offerings to individual investors are sold under the prospectus exemptions in NI 45-106, commonly with an offering memorandum. They reach investors through the same channels as other private investments: directly from the sponsor, through funds of funds, through exempt market dealers and through online platforms. In a limited partnership, income and losses generally flow through to the partners, who receive a T5013 slip for tax reporting.
Three features of the Canadian market bear on all four strategies. Changes in the Bank of Canada's policy rate pass through to floating-rate construction and bridge financing, so they reach value-add and development projects faster than lower-leverage core holdings. Regional markets differ: conditions in one city or province say little about another, and a strategy's results depend on where it is carried out. Development approvals are municipal, and their length varies widely by city and by project.
What holding the strategies involves
Across the spectrum, holding private real estate involves:
- A long horizon. Closed-end vehicles commonly hold property for several years, and the capital is generally committed until the property is sold. Open-end vehicles allow periodic redemptions, but they can limit or suspend them.
- Illiquidity. There is no daily market for these interests. Values are set by appraisal, and a sale before the vehicle's term ends depends on finding a buyer.
- Capital calls in closed-end and development vehicles, where commitments are drawn over time and further calls are possible.
- Different sources of return. In core and core-plus most of the return is income; in value-add and development most of it is a gain at the end, with little or no income until then.
- Results that turn on the sponsor. Execution drives the result, above all in value-add and development, which is why diligence practice concentrates on the sponsor.
Questions to ask
- Which strategy does the offering describe itself as following, and what in the business plan supports that label?
- What share of the projected return comes from income already in place, and what share depends on the plan or on the sale?
- What capitalization rate does the projection assume at sale, and how does it compare with the rate at purchase?
- What is the loan-to-value ratio, is the debt fixed or floating, when does it mature, and what happens if the property's value has fallen when it does?
- What is the renovation or construction budget, how much contingency does it include, and who bears cost overruns?
- What approvals are in place, and which are still needed?
- How are redemptions handled in an open-end vehicle, what limits apply, and have they ever been used?
- What comparable projects has the sponsor completed, what went wrong on any of them, and can the results be verified?
- What provision does the partnership agreement make for further capital calls, and what happens to a limited partner that does not meet one?
Key terms
- Core: a strategy that buys stabilized, substantially leased property and is held mainly for its income.
- Core-plus: a strategy that buys broadly stabilized property and seeks to add income through leasing, light improvement and management.
- Value-add: a strategy that buys property with a fixable problem and seeks to sell or refinance it at a higher value once the problem is fixed.
- Opportunistic: the highest-risk strategies, including development, major redevelopment and distressed acquisitions.
- Cap rate: a property's net operating income divided by its value or price; a higher cap rate means a lower value for the same income.
- NOI: net operating income, a property's rental and other income less its operating costs, before debt payments.
- LTV: loan-to-value, the property's debt as a share of its value.
- Bridge loan: short-term financing meant to be repaid by a refinancing or sale once a property's plan is complete.
- Open-end fund: a vehicle with no fixed end date that admits and redeems investors periodically.
- Capital stack: the order in which the providers of a property's financing are repaid, with lenders ahead of the equity.