Some sponsors of commercial real estate will boast that they can provide greater “risk-adjusted returns” for investors, but what does that truly mean?
One of the most fundamental financial principles, but only a small percentage of investors get it. Based on the level of risk associated with an investment, a risk-adjusted return is a metric that contextualizes results. In other words, an investor should anticipate a bigger return the greater the risk.
Measurement Of Risk
The Sharpe ratio is the most used metric for evaluating risk. By owning a riskier asset, you experience more volatility, which results in a greater excess return, which is represented by the ratio.
To quantify the reward per unit of risk, the Shape ratio is computed employing standard deviation and excess return.
You must evaluate an asset against a standard to determine how hazardous it is. Historically, the risk-free rate of return has been defined as the rate of interest on the shortest-dated US Treasury bill. Treasuries, like a 3-year bond. Despite having the lowest volatility of any asset, some contend that the risk-free security’s length should correspond to that of similar investment. This frequently involves employing a 10-year U.S. Treasury note in commercial real estate. Treasury was used as the standard. (It is also important to note that, regardless of the benchmark chosen, the rate of return is a theoretical one for zero risk; in the actual world, there’s no such thing as zero risk.)
The asset has historically performed better in risk-adjusted terms when the Sharpe ratio is greater. With the use of the Sharpe ratio, it is possible to assess the amount of risk that two different assets have to take on to generate excess returns over the risk-free rate.
Risk-Adjusted Returns In Commercial Real Estate
To further comprehend how this can appear in the area of commercial real estate, let’s look at an example.
You have the choice to put money into one of three commercial real estate transactions, each with a different predicted rate of return:
- Property A equals a 5% return
- Property B has an 8% return
- Return on Property C is 12% return
In the heart of Los Angeles’ core market, Property A is an apartment complex with institutional-quality living quarters. Property C consists of four 30-unit garden-style apartment buildings scattered across Indianapolis, whereas Property B is a 150-unit Class B apartment complex in the suburbs of Tucson, Arizona.
Given all other factors being equal, you would decide to invest in Property C due to its anticipated 12 percent rate of return.
However, you must take into account the greater risk involved with generating this possibly larger return before making this investment. You would probably discover that Property A undergoes some fluctuations for several real estate cycles if these assets were plotted on a Bell curve for more than 30 years. The asset yields a 5 percent return on average, with a potential 10 percent swing in either way. Investment B will have more moderate fluctuations, whereas Investment C will experience more frequent swings.
That is sensible in this instance. As compared to investing in a Class B apartment complex in a secondary market or a group of value-added garden-style apartment buildings in a tertiary market, a Class A apartment block in a core market is likely to be less risky. This is not to argue that either investment is a poor one, but rather that there is greater risk involved in buying a lower-quality property in a secondary market than there is in buying a more recent Class A apartment complex in a market that attracts the interest of institutional and foreign investors.
Investing professionals can go a step further. If you want to compare assets with comparable projected rates of return rather than those with differing rates, you can:
- Investment X yields a 10% return.
- Return on investment Y is 12 percent.
In this illustration, Investment X is an opportunity for value-added investment in a core market put up by a recognized sponsor. Investment Y is an equally sized value-add investment in a core-plus market that is put out by a sponsor with less expertise. In this situation, a potential investor would be logically inclined to accept a little lower rate of return in exchange for working with a reputable sponsor.
Model Deficiencies
The Sharpe ratio has certain drawbacks when it comes to producing risk-adjusted returns in commercial real estate.
The computation frequently involves data that is looking backward, which presents the first difficulty. Investors seldom ever possess the foresight to predict an asset’s performance over a 10-, 20-, or 30-year timeframe. Instead, since the aforementioned commercial development project may only be beginning, potential investors must assess how that sponsor’s total portfolio has performed with time.
The majority of risk-adjusted returns are computed using real estate indexes as a reference to examine the risk and returns of commercial real estate, which brings us to our second point, which is connected to the previous one. In contrast, investors seldom maintain portfolios that are as well-diversified as the indexes, and risk profiles at the property level are not always comparable to the risk profiles of bigger indexes.
The Importance of Due Diligence
Investors are urged to look a little further before investing rather than making a decision based only on predicted rates of return. Investors in commercial real estate might better comprehend project risk by performing rigorous due diligence. Some major hazards to think about are:
Age of Home: A newer property carries less risk when undergoing big capital improvements like a new roof or heating system. The likelihood that the main structural elements of an older property are getting close to the end of their useful lives increases.
Markets: Investments in core markets are often thought to be safer than those in secondary or tertiary sectors, as was previously said. Submarkets exist inside each market. When comparing two homes in the same core market, consider how comparable properties have fared in that particular submarket (e.g., how an apartment building performs in Chelsea vs. Greenpoint NYC.).
Sponsorship Quality: Consider a sponsor’s track record before investing. Check out their qualifications, prior work history, and product quality. Check-in particular to see if prior initiatives of theirs have met or surpassed expected rates of return. If a project does not meet expectations, investigate deeper to determine why, and urge the sponsor to clarify how they intend to manage project risks. In comparison to a rookie sponsor considering a transaction in a core market, it’s highly likely to be “safer” to invest with a greater sponsor in a secondary or tertiary market.
Use Diversification to Mitigate Risk
Just as it is recommended for stock and bond investors to diversify their holdings, commercial real estate investors should also do the same. You wouldn’t want to invest in every high-risk stock or opportunity in a speculative company, and the same is true for commercial real estate. Yes, the final profits could be bigger, but you risk losing a lot if things don’t work out as you had hoped.
Rather, real estate investors ought to diversify their holdings by choosing a variety of properties with varying levels of risk. This may entail making a passive investment in a fund that has properties of institutional caliber and collaborating with a highly skilled sponsor on a Class C value-add transaction. The ultimate objective should be to produce higher risk-adjusted returns, which necessitates diversifying in a way that minimizes risk and optimizes returns — a difficult endeavor that even the most experienced investors eventually struggle with.
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