Although it may seem incredibly elementary, the concept of risk vs. return is a fundamental driver of nearly all investment transactions – including those that involve commercial real estate assets. The more risk an investment involves, the higher the return an investor is going to demand for taking that risk. Or, to put it another way – low risk investments typically come with low, but stable returns while high risk investments can come with a high, but highly variable return. While simple on its face, the risk/return concept can become very complex when evaluating a range of investment opportunities.
In this article, we are going to zero in on one specific risk concept known as the risk premium. We will describe what it is, how it is calculated, and why it is so important when reviewing commercial real estate investment opportunities. By the end, readers will have a more thorough understanding of the risk premium concept and will be able to incorporate this knowledge into their pre-investment due diligence process.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. As part of our acquisition process, we perform a significant amount of Due Diligence – including evaluating the risk premium for all potential purchases. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
What is a Risk Premium?
The definition of a risk premium is simple, but the concept is much more nuanced and complex.
A risk premium is the excess compensation received when choosing a higher risk investment over a lower risk opportunity. To fully understand this point, it helps to think about risk on a spectrum. At the low end, investments like US Treasuries or Certificates of Deposit are very low risk investments that come with a similarly low return in the 1% – 3% range annually. Although these returns are low, they are stable and dependable.
At the other end of the risk spectrum is something like cryptocurrency, which has wild price fluctuations. With this asset class, investors have the potential to earn fantastic, but highly variable returns. To support this point, consider the price of Ethereum, a leading cryptocurrency. In a 12 month period, its price went from $2,608 per coin to a high of $4,867 and then down to a low of $879. Depending on where an investor made their purchase over the previous 12 months, they either made or lost a lot of money.
So, in the examples above, the risk premium is the difference between the low risk investment and the high risk investment – the compensation needed for taking more risk.
A Note About Risk Tolerance
While risk is a somewhat objective measure, an investor’s risk tolerance is much harder to define because it can vary so widely from one individual to another. Again, it can be helpful to think about this on a spectrum.
At one end of the spectrum investors with low risk tolerance have little appetite for potential losses and typically value capital preservation over potential growth. Often these may be older investors at or near retirement who need to ensure they do not lose any money. So, these investors may prefer to invest in lower risk opportunities like the bonds and certificates of deposit described above.
At the other end of the spectrum, investors with a high risk tolerance are in pursuit of a higher rate of return and are willing to potentially lose money as a result. Usually, these are younger investors with a long time horizon that could allow them to recover from any losses incurred. While these investors may not go so far as to invest in cryptocurrency, they may lean towards higher risk assets like those found in the stock market.
Investment risk tolerance is highly individual and is an important element in determining investment suitability.
What is The Risk Premium Formula?
For the sake of simplicity, the risk premium is calculated as the difference between the expected return on two investments.
For example, if a corporate bond has an expected total return of 3% annually and an investment in a S&P 500 Index Fund has an expected total return (including dividends) of 8%, the risk premium is 5%. This means that the investor could earn 5% more as compensation for the excess risk associated with the index fund investment.
What is The Risk Free Rate?
To be more specific, the risk premium is often measured relative to the so-called “risk free rate.”
The risk free rate is the interest rate paid on a 10-Year US Treasury Bond and it is considered to be “risk free” because it is backed by the full faith and credit of the United States Government who has the ability to levy taxes to generate funds for repayment. At the time of writing, it pays ~2.60% annually.
So, the idea behind the risk premium is that anything riskier than a 10-year Treasury has to offer a total higher return. For example, if a 10-year Treasury pays 3% interest and a commercial property investment also pays a 3% annual return, a rational investor would choose the lower risk option for the same return.
How a Risk Premium Functions in Commercial Real Estate
The risk premium concept drives nearly every facet of the commercial real estate market. Again, the idea is that the 10-year Treasury is the starting point for real estate returns. So, as it fluctuates, real estate returns typically move in tandem relative to the amount of perceived risk in each deal.
Returns are often stated by referencing a property’s capitalization rate – cap rate for short.
What is The Cap Rate?
A property’s capitalization rate is a return metric that provides real estate investors with an indication of the annual return produced by a property’s cash flows, assuming the property was purchased with cash.
The formula used to calculate the cap rate is Net Operating Income (NOI) divided by Purchase Price/Property Valuation. For example, if a property produced $100,000 in Net Operating Income annually and has a cost of $1,000,000, the cap rate is 10%.
Exploring the Relationship Between the Risk-Free Rate and Cap Rates
To understand the relationship between the risk free rate and the cap rate, it is helpful to return to the idea of risk on a spectrum. Except this time, the risk is represented by a property’s cap rate.
So, at the low end of the risk spectrum is the 10-year Treasury and the interest paid on it is, say, 3%. Based on the fundamental idea that commercial real estate is inherently riskier than a 10-Year Treasury, it stands to reason real estate investors demand higher returns than the risk free rate for any property. But, not all properties have the same level of risk.
Moving up the spectrum, something like a triple-net leased property with a single, credit tenant on a long term lease is about as risk free as a CRE investment can get. But, it is still riskier than a Treasury so it should return more, say 4.5%.
Continuing up the spectrum could be something like the types of grocery anchored retail we specialize in. It is riskier than a triple-net leased property so it should pay a higher return, say 5.5%.
Moving all the way to the far end of the spectrum, a property type like a ground up development or a major renovation/rebuild is the riskiest type of commercial real estate investment and should command the highest premium over the risk free rate.
Finally, it is important to note that markets are dynamic and ever changing. So, as the risk free rate changes, return requirements and cap rates may change alongside it.
The Predictive Power of Risk Premiums in Commercial Real Estate
Keeping an eye on the risk premium in commercial real estate markets can be a helpful way to forecast the future direction of commercial real estate prices/property values. To illustrate this point, consider a hypothetical scenario where the risk free rate is 3% and the market cap rate for a grocery store anchored retail center is 6%.
In this scenario, the risk premium is the difference between the risk free rate and the prevailing market cap rate or 3% (6% – 3%). Now, assume that the risk free rate rises to 4%. To maintain the same level of real estate risk premium, cap rates would have to rise to 7%, which means that prices would have to go down for investors to achieve that return.
Now, this example is simplified for illustrative purposes and the correlation between the risk free rate and cap rates is not always this clean. The important point here is there is always some level of volatility in real estate and capital markets, which can result in changes in asset pricing (up or down).
Risk and Commercial Real Estate Assets
At this point in the article, it is well established that real estate returns (and property prices) are measured relative to the risk free rate. And, lower risk assets provide lower returns while higher risk investments offer potentially higher (but more variable) returns. So, it follows that it is important for real estate investors to be able to spot the risk in a potential investment opportunity. In trying to do so, there are a number of factors to consider:
- Property Type: Based on their unique characteristics, some property types tend to be riskier than others. For example, grocery store anchored retail centers typically have less property risk than office properties or industrial assets.
- Markets: Risk can vary widely from one real estate property market to another. For example, high volume/high priced markets like New York or Los Angeles may have less risk than a far smaller market like Omaha or Des Moines due to slower growth rates, potentially higher vacancy rates, and the illiquidity associated with lower transaction volumes.
- Deal Structures: The way a deal is structured from a legal standpoint can have a significant impact on risk. For example, a single property deal may have more risk than a diversified portfolio of properties offered by a REIT.
- Management: The property operator/manager can also have a significant impact on the risk profile of an investment. Bigger, more experienced managers with the expertise and resources to do a good job represent less risk than a new or inexperienced operator.
- Market Risk: Finally, markets are inherently unpredictable. There will always be some level of market risk baked into a deal, but investors can pay close attention to trends and key metrics to anticipate where markets are headed and reduce their risk.
There will always be some amount of risk in every commercial real estate deal, but investors should work hard to identify it and take proactive steps to mitigate it.
Summary of Risk Premiums
In commercial real estate, the risk premium is the excess compensation received by an investor for taking additional risk in a deal.
In most cases, the risk premium is measured relative to the risk free rate, which is the interest rate paid on a 10-year Treasury.
The risk premium is calculated as the difference between the risk free rate and the potential return on a CRE investment, usually measured by the cap rate.
Every real estate deal has risk so it is the job of investors to identify where the risk lies in the deal and take proactive steps to mitigate it.
Want To Learn More About Commercial Real Estate Investing?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.