Starting out on your investment journey means learning about all the lingo and concepts that go into creating a smart and diverse portfolio, and that includes getting to know the J-curve. This concept is applied to a whole host of industries and fields, from politics to national trade balances, but this blog post will focus specifically on its use in private equity and real estate investments. Here’s all you need to beat the learning curve on the J-curve.
What is the J-Curve?
The J-curve, simply put, is the mapping of a significant loss followed by a substantial gain. When mapped out, the results create a J-shape, otherwise known as the J-curve. Economists might use this trendline to show depreciation and appreciation in currency or national trade deficits and surpluses. For private equity real estate investments, the J represents several key factors:
- Initial investment
- Initial deficit or loss
- Eventual profit
All three of these factors are mapped over time, with the sharpest drop down occurring just after the initial investment/asset acquisition. Breaking down each one can provide a better understanding of this model and why it’s helpful for investors to understand.
Initial Investment
The initial investment is the acquisition of an asset. For DiversyFund and other REITs, this means adding the property to its portfolio of holdings. An individual investor can start the J-curve with a single purchase, such as a rental home or stand-alone retail building. We can also look at this first step as the deployment of capital for investment. It is, essentially, the cost of purchasing an asset, and the J-curve model begins with this part of the process.
Initial Deficit or Loss
After deploying capital, a real estate asset will face an initial deficit or loss. The loss creates the dip into the negative on the J-curve trendline. This dip may be the result of acquiring a property that was previously run poorly, but even assets that are maintained properly will see an initial deficit or loss. A REIT or individual investor will look at improvements for the property, such as repairs and maintenance, which requires additional funds beyond the initial investment. These added costs represent a deficit. Some examples of costs resulting in a deficit might include:
- Replacing roofing, plumbing, or appliances
- Previous tenant turnover
- Painting, refinishing, and other cosmetic refurbishments
While these improvements come with a price tag, they are integral for completing the J-curve. Without them, the curve might not dip below 0, but it may also stay flat or negative instead of completing the J and showing positive growth. Some investments that don’t do a good job of asset management may reach the breakeven point without ever climbing any higher, which means little to no growth over time.
Eventual Profit
While the negative dip in the J-curve is necessary, the end result of the trendline should be a move into the positive. An asset can begin to become profitable with the capital improvements represented in the dip. So how does this work? The improved property can net higher rents, leading to better cashflow for the property. Dealing with tenant turnover and acquiring qualified renters for each unit in an apartment building helps maximize the asset’s potential for monthly income, and cosmetic improvements work to make the property more appealing to future tenants. All these factors help ensure reliable monthly cashflow in line with the asset’s profit potential.
It’s important to note that not every real estate investment will be able to complete the J-curve. Investors who don’t make the necessary improvements to a property may have a hard time improving cashflow each month, and some properties may not have as much growth potential as others. The J-curve represents the desired outcome, but it is up to the REIT or individual investor to carefully select assets for investment and make sure they are managed property.
What the J-Curve Means for Investors
Just like other mathematical models, predictors, and reports, the J-curve is just one tool you can use to evaluate potential investments. The ideal J-curve is one that has a steep upward trajectory after the initial deficit/loss. This means that the investment, such as a real estate asset, was able to recoup losses quickly. DiversyFund uses the J-curve as part of our value-add strategy of purchasing multifamily assets, renovating them, and then waiting for the right time to sell, increasing potential returns and creating a strong J-curve for our investors. Of course, an investment with slow and steady growth can be ideal for those who have less risk tolerance. Be sure to discuss any financial moves with your advisor before making a decision and consider using the J-curve as part of your research as you look for different investment opportunities.