Risk is an inherent part of any investment but, in real estate investing, the term “risk adjusted return(s)” is frequently seen.
As we have discussed previously, when investing in real estate, investment returns and the associated risk in obtaining such returns are highly correlated. To most investors, it’s clear that the higher the risk an investment has, the higher the potential return will be. Conversely, for investments offering lower risk, potential return will be lower.
But not all elements of the same investment have the same risk so, in order for investors to understand what part of their investment return is associated with risk, it’s possible to calculate the risk adjusted return..
So, let’s have a look at how this is done.
How to explain Risk Adjusted Returns
A risk adjusted return is a fundamental concept in real estate which endeavours to assess how much risk must be taken to achieve the targeted or potential investment returns from a property investment.
As risk and investment returns are closely correlated, with higher risks associated with higher returns (with perhaps greater volatility) and lower investment risks with more stable, but lower returns, the key question is “how to measure risk in a commercial real estate investment such as investing in multi-family assets?”
There are two ways to measure such risk and these are “qualitative” and “quantitative”
Qualitative risk factors
Qualitative risk factors which real estate investors need to consider include:
- Type of asset: traditionally, certain real estate asset classes are considered as riskier than others.
At the more secure (stable) end of the property spectrum are assets such as multi-family apartments or prime retail spaces which are leased to necessity retailers such as daily food suppliers. Throughout all phases of the economic cycle, such assets are likely to deliver stable cash flows.
On the other hand, at the riskier end of the investment spectrum are property asset classes such as hotels which offer transient accommodation or restaurants which are subject to discretionary not necessity spending. These types of asset classes typically offer higher returns, but also may be subject to higher risk.
- Location and market size: has always been one of the key maxims of any property investment. The nature and type of the market in which a property is located or serves invariably has a major impact on its risk level. Larger markets with high levels of demand and transactional volume will clearly be less riskier than smaller, more illiquid markets.
- Age: usually older properties which have not been well maintained or have become obsolete in terms of certain systems and functionality present more risk than more modern properties. With an older building there is more likelihood of major repair items and costs arising and which have to be addressed from the property’s operating reserves or have an impact on cash flows for many years.
- Duration of leases: the lease profile of tenants in a building can also affect risk. If a property has a high percentage of existing leases with a relatively short amount of time, risk levels are higher because some tenants may not renew their leases, meaning that landlords potentially have vacancies or will need to re-lease the space at lower rates than that paid by previous tenants. Clearly, properties with a high percentage of longer term leases have less risk because future cash flows are more certain.
- Nature of tenants: investment returns are usually predicated upon the premise that tenants will continue to pay their rent every month and that vacancies are kept to a minimum. Accordingly, larger tenants with stable financials and a demonstrable track record of on time rent payments represent much less risk than smaller companies just starting out in business.
[ Passive investors : do you know how to vet a real estate investment group before making an investment?
Download and read our FREE e-book: 25 Fundamental questions to ask a Syndication Sponsor before making your investment. ]
Every property is unique in terms of location, design and usage and can have higher or lower qualitative risk factors depending upon its specific investment profile.
Therefore, all real estate investors need to review the qualitative risk factors of a property before making a judgement about its risk return profile.
Quantitative risk factors
As part of the risk return assessment of a property, many investors turn to quantitative real estate metrics. The two most commonly used metrics associated with risk returns are known as the Treynor Ratio and the Sharpe Ratio.
- The Treynor Ratio
The Treynor ratio seeks to quantify the risk adjusted return on a real estate investment by endeavouring to understand how well a property portfolio performs relative to equity markets. In terms of risk return measurement, this differs from the Sharpe Ratio discussed below.
The Treynor Ratio will quantify how much a real estate investment over/under performs equity markets; for example: if a composite of stock market indices has a rate of return of 14% and a portfolio or real estate investments has a total return of 18%, then the 4% difference in return can be associated with the composition of the real estate investment portfolio.
- The Sharpe Ratio
On the other hand, the Sharpe Ratio seeks to quantify the excess return over the risk free rate
This financial metric was specifically developed for the purpose of trying to help investors measure the risk adjusted returns of an investment opportunity.
The formula used to calculate the Sharpe Ratio can be complex, but essentially is the risk free rate subtracted from the investment return of the portfolio with the result divided by the standard deviation of the portfolio’s excess return.
In other words, the return from the property portfolio less the risk free rate is intended to identify the return associated with the risks in the transaction.
If, for example, the rate on a 10-year Treasury bond (the so-called risk free rate) is 3% and the portfolio return is 14%, the 12% excess return is associated with the additional risk in the transaction. When this figure is divided by the standard deviation which represents a measure of volatility a quantitative measure of the risk adjusted return results.
Why it’s important to understand risk-adjusted returns
An individual’s investment strategy will involve their own tolerance for risk, with some investors able to stay focused on the longer term returns, overlooking occasional periods of volatility, but others preferring to stay with lower but more stable returns.
In the event, for example, of a composite return from a stock market investment of, say, 12% and a real estate investment indicating an IRR of 16%, it would be a reasonable assumption that the latter involved more risk than the market as a whole
On the other hand, if such a real estate opportunity had an expected return of 6%, the opposite might be true.
In short, investors able to tolerate more risk might choose an investment strategy with a higher Treynor Ratio and those with a lower risk tolerance, investments with a lower ratio.
Quality due diligence is essential
For any investment, but more so when there are potentially higher risks, quality due diligence on both a quantitative and qualitative basis is vital. The three most important reasons for this are as follows:
- Understanding risk factors: comprehensive due diligence will help to identify the source and amount of risk in any given investment opportunity and allow investors to take pro-active steps to mitigate the same;
- Expected returns: quality due diligence will review the fundamentals of a transaction in detail to assess the expected returns; such review will look at loan interest rates and the expected holding period, for example.
- Suitability: A detailed understanding of risk in a real estate investment allows investors to identify and pursue opportunities that are most suitable for their own risk tolerance. For example, those with a lower risk tolerance may want to stick with a diversified portfolio of lower risk asset classes like multifamily and grocery anchored retail. Those with a higher risk tolerance could gravitate towards high risk/high reward opportunities in development or vacant land.
Diversification is one of the fundamental concepts in investment management to help with risk mitigation. This means that, instead of investing all of the available capital into one asset, savvy investors will spread such capital over multiple investment options or property asset classes in order to mitigate risks or unexpected occurrences with being invested in only one property.
An example is as follows:
- an investor with $100,000 invests the whole amount into a single, class B rental property;
- another investor spreads this $100,000 into four parts and places $25,000 into bonds, $25,000 into stocks and shares, $25,000 into a REIT, and keeps $25,000 in cash.
In the event that the real estate market declines by 10% the first investor with a 100% real estate holding will see a greater decline than the other investor who has spread their capital over multiple asset classes, with only 25% being in real estate..
As part of the extensive due diligence which CPI Capital always undertakes in respect of any REPE investment we are reviewing, Risk-Adjusted Returns are always close to the top of the list.
Risk management requires near constant vigilance and a high degree of experience and expertise which fortunately we have within our team at CPI Capital.
For any investors who don’t have the time, experience or appropriate knowledge to handle their own risk management activities, it’s clearly beneficial to partner with a private equity firm to identify and mitigate risk in any commercial real estate investment.
CSO, COO, Co-Founder CPI Capital