Imagine a scenario where an individual is trying to decide which one of three commercial real estate investment opportunities to invest in. Common sense dictates that they should just choose the one with the highest potential return. This approach isn’t wrong, but it ignores one major element of the investment…risk.
In this article, we are going to discuss risk adjusted returns in commercial real estate. We will describe what they are, why they matter, and demonstrate how to calculate them. By the end, readers will have the information necessary to incorporate risk into their own investment decision making process.
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What Are Risk Adjusted Returns?
A risk adjusted return is a foundational real estate concept that attempts to put potential investment returns in the context of how much risk must be taken to achieve them. Or, put another way, it means that risk and return are closely correlated. The higher the risk in an investment, the higher the return that investors should expect – with potential volatility. Conversely, the lower the risk in an investment, the lower (but more stable) the return.
With this definition in mind, the next most logical question is “how does one measure risk in a commercial real estate investment?” There are both qualitative and quantitative ways to do it.
Qualitative Risk Factors
In commercial real estate, there are a number of qualitative risk factors that investors should consider. They include:
- Asset Class: Historically, some real estate asset classes are riskier than others. At the safe end of the spectrum are property types like multifamily and grocery anchored retail, which tend to deliver fairly stable cash flows through all phases of the economic cycle. At the riskier end of the spectrum are asset classes like hotels, restaurants, and vacant land. In the long run, these asset classes may offer higher returns, but they may also be more volatile and come with higher risk.
- Tenant Base: Earning a return at all is predicated upon the idea that tenants will continue to pay their rent, in full, every month. So, tenants with stable financials and a demonstrable track record of on time rent payments represent much less risk than tenants with questionable finances and a spotty track record of rent payments.
- Lease Term: If a property has existing leases with a short amount of time left in the term, the risk is higher because the tenant may not renew their lease, causing the owner to potentially have to re-lease the space at a rate that is lower than the one the previous tenant paid. Properties that have existing leases with long terms remaining have less risk because the future cash flows are more certain.
- Age: Generally, older properties that have not been well maintained represent more risk than newer properties. This is because there is the potential for a surprise major repair cost in an older property. For example, an unexpected roof replacement could wipe out a property’s operating reserves or impact cash flows for years into the future.
- Location: The market in which a property is located has a major impact on its risk level. Smaller, less liquid markets may pose more risk than larger markets with high levels of demand and transaction volume.
These are not hard and fast rules. Every property is unique and can have higher or lower qualitative risk factors based on its own investment profile. The broader point is that investors should take the time to recognize the qualitative risk factors of a property and adjust their return expectations accordingly.
Quantitative Risk Measurement
For those investors that like more quantitative real estate metrics, there are two ways to measure risk:
The Sharpe Ratio is a financial metric that was developed specifically for the purpose of trying to help investors measure the risk adjusted return of an opportunity. The formula used to calculate it can be complex, but the key point is that, in it the risk free rate is subtracted from the portfolio return and the result is divided by the standard deviation of the portfolio’s excess return.
In plain language, the portfolio return less the risk free rate is meant to identify the return associated with the risk taken in the deal. For example, if the rate on a 10-year Treasury bond (the risk free rate) is 3% and the portfolio return is 15%, it could safely be concluded that the 12% excess return is associated with the additional risk in the deal. When this number is divided by the standard deviation – a proxy for volatility – investors can get a quantitative measure of the risk adjusted return.
The Treynor Ratio
The Treynor ratio is another metric that seeks to quantify the risk adjusted return on a real estate investment. However, in this case, it uses a different point of reference. Whereas the Sharpe Ratio seeks to quantify the excess return over the risk free rate, the Treynor Ratio seeks to understand how well a portfolio performs relative to equity markets.
For example, if a composite of stock market indices has a rate of return of 15% and a real estate investor portfolio has a total return of 18%, then the Treynor ratio holds that the 3% excess return can be associated with the composition of the real estate investment portfolio.
In other words, the Treynor ratio will quantify how much a real estate investment over/under performs equity markets.
The Importance of Understanding Risk-Adjusted Returns
Again every individual has their own tolerance for risk. Some may be able to stay focused on the longer term and ignore intermittent periods of volatility. Others may get nervous when they see big swings in portfolio returns.
It is precisely this tolerance for risk that can drive an individual’s investment strategy, which is why it is important to understand risk adjusted returns. To illustrate this point, consider an example using the Treynor Ratio.
Suppose the stock market had a composite return of 10%. If a real estate investment was advertising an IRR of 18%, it is a safe assumption that this investment opportunity has more risk than the market as a whole. But, if that commercial real estate (CRE) opportunity had an expected return of 6%, it is safe to assume that it has less risk than the overall market. Thus, the conclusion is that investors who can tolerate more risk might choose a strategy with a higher Treynor Ratio. Or, investors with a lower risk tolerance, should look for investments with a lower Treynor Ratio.
The Importance of Due Diligence
Any time there is risk in an investment, it is a good idea for individuals to perform their own due diligence on it. There are a number of reasons why this is true, but the three three most important are highlighted here:
- Understanding of Risk: A thorough due diligence effort helps to identify the source and amount of risk in a given investment opportunity. Knowing where the risk lies allows investors to take proactive steps to mitigate it.
- 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.
- Expected Returns: Finally, a good due diligence effort reviews the fundamentals of a deal – like loan interest rates and the expected holding period – to assess the expected returns.
When investing in real estate assets, it is always a good idea for investors to complete their own due diligence – on both a qualitative and quantitative level – and choose the option that is most suitable for their own preferences.
Diversification in Risk Mitigation
Any discussion of risk would not be complete without a mention of mitigation strategies. One of the bedrock risk mitigation in investment management is a concept known as diversification. This term simply means that it is a good idea for investors to spread their capital over multiple options instead of just one. To prove this point, consider the following example.
Suppose that an individual has $1,000 to invest. In option A, they take the entire amount and invest it in a single, class C rental property. In option B, they invest $250 in bonds, $250 in stocks, $250 in a real estate investment trust (REIT), and hold $250 in cash.
Now, suppose that real estate market conditions deteriorate and the ensuing downturn results in a 15% decrease in real estate prices. In option A, the investor’s portfolio is entirely devoted to real estate so they are likely to be hit harder than the investor in option B who spreads their capital over multiple asset classes.
At First National Realty Partners, we believe that commercial real estate deserves an allocation in a broadly diversified portfolio of risk assets.
Risk-Adjusted Returns in Private Equity Real Estate Investing
Risk management is not a one-time activity. It requires near constant vigilance and a high degree of experience and expertise. Not all investors have the time and knowledge to dedicate to their own risk management activities. Those that don’t may find that it may be beneficial to partner with a private equity firm to identify and mitigate risk in a commercial real estate investment.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.