Defining Flight-to-Quality Investments in Residential Real Estate

May 22, 2020 | Sundae Investor Team

Flight-to-quality, also called flight-to-safety, is a common financial market phenomenon that describes the behavior when an investor sells a perceived high-risk asset during a financial downturn and switches to safer investments. In financial markets, investors may shift to blue-chip stocks and Treasuries because they seem relatively safer in the downturn.  

Real estate, like the stock market, has its share of ups and downs.  After a period of record highs, despite COVID-19 forcing the broader economy into a slump, real estate market fundamentals are resilient for now. Savvy real estate investors who employ next level thinking are already flocking to “quality” investments. They believe these safer assets and strategies will perform well through the challenging conditions. 

Commercial real estate investments are classified into four different segments based on characteristics of the deal.  We took a stab at creating the same categorization for residential real estate assets and deals.  

Category 1: Core Investments

Core investments have the least perceived risk. First-time homebuyer properties with light rehab and within FHA limits fall into this category. 

A nice 3 bedroom, 2 bathroom home with a backyard in a thriving suburban location, with a good school district and low crime rates, that can be turned around in a short period of time with light rehab is a definite winner. A cul-de-sac location and a walking distance to the park are a nice cherry on top. 

Before/After Example of Core Investment Property

Category 2: Core-plus Asset Investments

Core-plus assets are similar to the core investments but add a “growth” component. All of the same definitions would apply, but the rehab is more extensive, might include adding a window, and landscaping to better the curb appeal. The holding time is longer due to the prolonged construction timeline.

Before/After Example of Core-plus Asset Property

Category 3: Value-add Investments

Value-add investments offer tremendous return potential once the property’s physical and operational issues are improved.  For example, you might have a 2 bedroom, 1 bathroom in a 1,200 square foot house. Reframing a walk-in closet into a second full bathroom or adding another bedroom within the existing floor plan could turn the house into a more desirable property that can be sold for a sizable profit. 

Another way to add value in such a property is to create an open concept floor plan by opening up the kitchen wall. On the risk vs. return spectrum, value-add real estate assets hold a middle ground between the less risky (core or core-plus) and riskier (opportunistic) investment strategies because of the execution risk and longer time it takes to turn the property around.

Before / After Example of Value-Add Investment Property

Category 4: Opportunistic Investments

Opportunistic investments are the riskiest deal types that have much longer investment horizons and require major renovations. Examples of opportunistic deals are adding an ADU (Accessory Dwelling Unit), splitting a lot and building a second structure, or selling the land and expanding square footage. Opportunistic deals are highly speculative in nature, with big risk and big reward potential.

Location, Location, Location

In addition to the strategies outlined above, when real estate investors face a high level of uncertainty, geographic considerations play an important role in flight-to-quality. Investors will avoid properties with external obsolescences like busy roads, locations with commercial buildings, multifamily apartments, a landfill next to the neighborhood, high-voltage towers, proximity to or being in a river flood zone, or backing a highway or railroad tracks. 

At this point in the market cycle, flight-to-quality means evaluating locations, intrinsic property characteristics, and strategy type. Core, core-plus, and value-add investments in solid geographic locations are the most safely positioned to weather the market storm.   

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