Quantifying the Risk Premium in Non-Core Commercial Real Estate 

In commercial real estate (CRE) investing, the distinction between “core” and “non-core” strategies is broadly employed, yet the specific return premiums that should accompany higher-risk investments are difficult to pinpoint. This is where defining – and quantifying – the risk premium of any given investment is crucial. A core investment is usually defined under the NCREIF Open End Diversified Core (ODCE) Index criteria, where a fund must be at least 75% invested in properties that are over 75% leased and employ limited leverage. 

Non-core investments—loosely categorized as “value-add,” “core-plus,” or “opportunistic”—exist on a spectrum of higher risk strategies, characterized by lower initial occupancy, higher cap-ex needs, and greater leverage. Theory suggests that these strategies should deliver higher total returns to compensate for the additional risk. However, comparing performance is complicated by variables such as opaque debt costs and the lack of same-store return series for non-core assets. 

Despite these data hurdles, it is possible to get at an appropriate risk premium using various market signals and benchmarks. 

1. Fund-Level Target IRRs 

One method to estimate the required premium is to analyze the targeted returns of closed-end value-add funds against contemporaneous core estimates. Return targets from the NFI-CEVA index (which tracks value-add funds), when de-levered using prevailing debt costs, show a high correlation with Green Street’s unlevered core return estimates. 

These de-levered target IRRs reveal a consistent spread to core strategies. From 2011 to 2022, the average difference between the targeted unlevered returns of value-add funds and core estimates was approximately 160 bps. 

2. Development Spreads 

Public market data provides a second reference point. Over the last decade, expected development spreads have averaged 150 to 200 bps over nominal cap rates. Adjusting for time-value-of-money effects yields an estimated spread of ~160 bps between core and development project IRRs. While development is riskier than a typical value-add project, the figure aligns closely with fund targets. 

3. Pension Benchmarks 

Pension funds utilize various CRE benchmarks, but where non-core strategies are explicitly tracked, they typically target 50 to 300 bps over ODCE total returns on a levered basis. When adjusted for average leverage differences between core and non-core funds, this translates to an unlevered return premium of 40 to 180 bps. The 160 bps derived from the previous methods sits at the upper end of this range. 

The Academic Reality Check 

While market signals converge on a ~160 bps unlevered spread as a fair “betting line” for the value-add risk premium, historical performance paints a bleaker picture. Academic consensus suggests that private non-core vehicles often fail to deliver attractive risk-adjusted returns. Research indicates that the higher fees associated with value-add and opportunistic funds erode net alpha, often resulting in returns lower than their core peers. 

A mid-one percentage point spread in expected IRR between core and higher-risk strategies is commonly used, implicitly and explicitly, by many market participants, but it serves more as a rough rule of thumb than a guaranteed outcome. On an unlevered basis, many higher-risk, cap-ex intensive strategies have historically failed to earn their keep. This discrepancy underscores the critical importance of utilizing high-quality data and granular analytics to rigorously evaluate the specific risks and projected returns of any commercial real estate investment on a case-by-case basis.