This article is part of our passive investors guide on real estate syndications, available here.
How will your investment perform, and is it worth the risks? You can’t know unless you look at the relationship between risk and reward, otherwise known as the risk-adjusted return. This calculation gives feedback on how much risk is worth the increased chances for above-average returns.
In this guide, we’ll break that down for you in the context of analyzing commercial real estate investments.
What is a Risk Adjusted Return?
Risk-adjusted return assesses an investment’s performance over time within the context of the assumed risk. Risk is defined as the likelihood that an investment’s performance will vary from expected outcomes. Generally, a high-risk asset is more likely to see performance variants than a low-risk asset. Risk-adjusted return ultimately helps you to make an informed investment decision.
Risk-adjusted returns can be calculated with any asset, whether a mutual fund, stock, or property. Next, we’ll discuss risk-adjusted returns and show you how risk-adjusted return on capital is explicitly calculated for commercial real estate.
How a Risk Adjusted Return on Capital is Calculated in Commercial Real Estate
Risk-adjusted return for commercial real estate (CRE) is calculated by subtracting the risk-free rate from the investment’s return and then dividing by the investment’s standard deviation. The result is often called the Sharpe ratio. The Sharpe ratio measures an investment risk versus return, compares two investments (or more), and helps gauge investment quality. A higher Sharpe ratio means a lower-risk investment.
The risk-free rate is the rate of return of an investment with zero risk involved. Treasury bonds are often used as the benchmark index for a risk-free instrument. For example, a Treasury bond offers a 3% return. The risk-free rate would be 3% as it represents a risk-free investment, meaning alternative investments in the market should be offered at a minimum of 3%. The standard deviation is the statistical measure of an investment’s broad range of returns relative to its average return and is a way to measure volatility easily. A higher standard deviation means more volatility and how much an asset’s returns vary.
An investment’s Sharpe ratio gives you a more accurate picture of an asset’s true long-term return relative to risk levels. This model is beneficial when comparing several properties with different return rates to find the one with the better risk-adjusted return.
Let’s consider a scenario where you’re choosing between these three properties:
- Property A = 7% return, 3% standard deviation
- Property B = 9% return, 5% standard deviation
- Property C = 12% return, 10% standard deviation
(Let’s assume the risk-free rate, or rate of return on Treasury bonds, averages 3% for the observed period)
While Property C looks like the winning investment compared to the others based on its 12% rate of return, you can’t know that for certain until you calculate the risk-adjusted return based on its standard deviation. Pan out 30 years. Calculating risk-adjusted return may show that Property A has less downside risk during the observed period compared to Property C.
Next, Property B sees some minor swings, represented by its lower standard deviation. Finally, Property C has the widest swings on a yearly basis. As an investor, you must decide how “worth it” the years of wild swings are for your portfolio. Is a nearly consistent 7% return better for your stability than a long-term 12% return that has years of wild ups and downs?
Which is better for your market portfolio: riskier investments with higher mean or average returns or investments with less risk but lower returns?
What makes these three properties have different return rates in the first place? Next, we’ll cover the factors contributing to lower risk and higher reward in CRE.
Factors That Play a Role in Risk & Reward in CRE
Variables affecting both cost of ownership and desirability among tenants impact CRE risk and reward. Here’s a look at the core points:
- Property Vintage (Age of the Property): Buying an older property increases the likelihood of major capital investments tied to repairs, renovations, and safety upgrades. However, buying a slightly older property needing work is one of the tricks to getting a stabilized property.
- The Deal’s Submarket: In addition to looking at the health of the city-defined market where a property is located, investors also need to look at the submarket. The submarket can refer to a specific neighborhood, zone, or suburb. A comparative analysis always includes properties within the same submarket.
- The Tenant Demographics: What percentage of the tenant base is college educated, are they white-collar or blue-collar workers, what is the average age of the tenant base, and what is their median household income? These are a few inputs we’d like to know about who occupies the units or the area, and we use this to try and understand what it means for the area’s ability to absorb future rent increases.
- The Unit Count: Unit count matters because the larger number of units creates a more diversified environment for the property to absorb natural vacancy and still be cashflow positive or break even in the worst-case scenario.
- Size of the Asset: Square footage determines usage type. Usage type determines rent potential.
- Existing Occupancy: Acquiring a commercial property that has existing tenants provides income stability from day one.
- The Amount of Renovation Dollars Needed: In addition to capital expenditures, renovations can prevent an investor from moving tenants in for immediate income streams. If major renovations will likely be needed in a few years, there’s a risk of disrupting revenue streams due to a need to relocate tenants during construction.
- Its Future Rent: In emerging markets, investors expect to see significant rent growth year over year, further insulating the property from inflation. But in some declining or flatlined markets, this future rent growth is more stagnant.
Risk understandably makes income-seeking investors shutter. Next, we’ll show you which asset classes are best for generating passive income with as little risk as possible.
The Asset Class & Investment Strategy That Offers the Highest Risk-Adjusted Return?
The multifamily asset class is the winner for generating immediate income with low risk. However, it’s not just about grabbing any multifamily property you can find for sale. Yes, you can get conservative returns by using a core multifamily strategy. Investors getting moderate-to-high returns use the value-add strategy to further increase the property’s ability to produce strong appreciating yield and value for its investors.
Using the value-add method, you’ll purchase a time-tested hard asset that hedges against inflation through adjusted leases every 12 months. This asset class is stable because it provides a core human need. A strategy of purchasing properties sometimes 30 to 40 years old allows you to purchase a stabilized property at well below replacement cost. Most have 90% minimum post-closing occupancy. That means that in many cases, investors will receive their portion of cash distributions from the first day.
While physical and operational improvements may be needed, these upgrades add value for higher net income collection. In fact, long-term tenants will be more likely to stay when they see improvements being made instead of dealing with the ongoing bidding wars for apartment leases happening throughout the country.
Renovation periods are ideal times to boost a property’s rent potential by adding security features, special outdoor amenities, and interior luxury amenities that boost desirability in the eyes of tenants.
Next, we’ll show you specifically how to do a market risk assessment for a value-add property.
Related Read: Pros & Cons of Investing in Real Estate
How to Do a Risk Assessment for a Value-Add Property
Consistency is the deciding factor when choosing a value-add property over a core or core-plus stabilized property with smaller areas of ways to add significant value to a property.
While a value-add property might be 30 to 40 years old, a core or core plus property is no more than 10 to 20 years old. Let’s use a scenario where we compare a 14% return rate on a core plus property to a 12% return rate on a value-add property. In this scenario, an investor prioritizing consistent returns would select the 12% return over the 14% return if it came with long-term tenants in a growing market based on the desire to shield against “bad years.”
Although that may be true, the type of value-add property or the level of value post-closing changes the risk and return profile. For example, suppose I’m buying a fully stabilized, 95% + occupied property in a growing market with low supply. In that case, the business plans to inject capital into the property to add more value to the tenant base and then charge more for rent.
This would have a similar level of risk as a slightly newer stabilized property as the property is already fully stable and produces a substantial yield, with the upside to make the property fresher and increase its yield and value.
Let’s spin through some of the common questions about risk-adjusted returns.
Frequently Asked Questions About Risk Adjusted Returns
Risk-adjusted return on capital (RAROC) is one risk-adjusted return measure used by investors to weigh the return on investment. RAROC allows investors to compare income versus expected losses to verify that riskier investment projects are likely to be accompanied by higher returns.
Risk tolerance varies by an investor. Knowing the risk level of an investment project allows investors to make informed decisions based on how much exposure they are willing to take on for the sake of potentially higher investments.
Risk Adjusted Returns in Commercial Real Estate - Conclusion
In commercial real estate investing, you can’t know the rewards until you know the market risks. Performing due diligence regarding a property’s age, condition, occupancy rate, and submarket allows you to understand its income potential versus liability compared to other properties.
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- Fortune, “Housing shortage brings bidding wars to rental market“
- Apartments.com, “The Top Amenities Renters Are Searching For“
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