Most stock market investors are familiar with Fama and French three-factor model used by Morningstar to explain the differences in the returns of diversified equity portfolios. It is a visual measurement of the balance between risk and return. We are going to a similar investment model to help you measure the risk versus return when you make your real estate investments.
How the Morningstar Grid Works
This investment model measures three different types of investments (Large, Medium and Small Caps) and it compares them against three different types of income streams (Value, Blend and Growth).
Large Cap stocks are companies with market caps that are above $10 billion. Their size makes them much more stable and less volatile to individual account fluctuations.
Medium Cap stocks consist of companies with market caps between $2 billion and $10 billion. They offer more growth potential than large cap but less risk than small cap.
Small Cap are made up of small companies with market caps below $2 billion. These are often young companies with significant growth potential but carry a greater risk.
Value Funds are discounted stocks that pay dividends and focus less on long-term appreciation.
Growth Funds focus on long term capital appreciation over dividend payouts.
Blend Funds are a combination of both value and growth funds.
The Real Estate Investment Model
Let take the Morningstar investment model and change it to measure income producing real estate investments. This chart now measures three different types of investments (Low, Medium, and High Cap Rates) and it compares them against three different types of cash flows (Income, Blend and Appreciation).
Low Caps have a capitalization rate that is less than 5 percent. These are low risk properties that have either a stable cash flow or limited market appreciation – or both.
Medium Caps offer a moderately stable cash flow with reliable market appreciation. They offer a mid-range cap rate of between 5 and 10 percent.
High Cap are high risk investments that offer a cap rate higher than 10 percent. They have volatile cash flow streams and limited price appreciation.
Income based cash flow focuses entirely on the rental income stream.
Appreciation based cash flow places the investment emphasis on price appreciation rather than the rental income that the property generates.
Blend cash flow investments offer a combination of rental income and price appreciation.
How to Use the Real Estate Investment Model
Comparing your current and future property investments to this real estate investment model can help you to balance your real estate portfolio. Here is a basic idea of where different property types fall within this investment model.
In our next article, we will show you how to use this investment model to balance your investment portfolio. A balanced investment portfolio will help you to ensure that your real estate portfolio meets your investment goals and risk tolerance.