“Risk-adjusted returns” is one of the most basic premises in finance, but one that few investors truly understand. A risk-adjusted return is a measure that puts returns into context based on the amount of risk involved in an investment. In short, the higher the risk, the higher return an investor should expect.
The most common way to measure risk is by using the Sharpe ratio. The ratio describes how much excess return you receive for the extra volatility you endure for holding a riskier asset.
The Shape ratio is calculated by using standard deviation and excess return to determine reward per unit of risk.
To understand how risky an asset is, you need to compare it to some sort of benchmark. Traditionally, the risk-free rate of return is the rate of return on the shortest-dated U.S. Treasury, such as a 3-year bond. While this type of security has the least volatility, some argue that the risk-free security should match the duration of the comparable investment. In commercial real estate, this often means using a 10-year U.S. Treasury as the benchmark. (It’s also worth noting that whichever benchmark is used, it is a theoretical rate of return for zero risk; in the real world, there is no such thing as zero risk.)
The higher the Sharpe ratio, the better the asset’s historical risk-adjusted performance. The Sharpe ratio can be used to compare directly how much risk two assets each had to bear to earn excess return over the risk-free rate.
Risk-Adjusted Returns in Commercial Real Estate
Let’s use an example to better understand what this might look like in the commercial real estate world.
You have an opportunity to invest in one of three different commercial real estate deals, each with different expected rates of return:
- Property A = 5% return
- Property B = 8% return
- Property C = 12% return
Property A is an institutional-quality apartment building located in downtown Los Angeles, an area considered a core market. Property B is a 150-unit Class B apartment building located in suburban Tucson, AZ. Property C is a collection of four Class C, 12-unit garden-style apartment buildings located in Mobile, AL.
All else considered equal, you’d choose to invest in Property C given its projected 12% rate of return. But before making this investment, you must consider the additional risk associated with earning this potentially higher return. If these assets were to be mapped on a Bell curve over a 30-year period, you will likely find that Property A experiences some swings over the course of multiple real estate cycles. Perhaps there’s a 10% swing in either direction, but on average, the asset generates a 5% return. Investment C will endure wider swings year in and year out, with Investment B somewhere in between.
In this example, that makes a lot of sense. In general, we would expect a Class A apartment building located in a core market to have less risk associated with it than investing in a Class B apartment building in a secondary market, or a collection of value-add garden-style apartment buildings located in a tertiary market. It is not to say that any of the investments are bad ones—but rather, there is more risk associated with investing in lower-quality product in a tertiary market compared to investing in a newer, Class A apartment building in a market that draws attention from institutional investors.
Investors can take the premise one step further. Instead of comparing investment opportunities with different expected rates of return, you can look at investments with similar expected rates of return:
- Investment X = 10% return
- Investment Y = 12% return
In this example, Investment X is a value-add investment opportunity proposed by a reputable sponsor in a core market. Investment Y is a similarly-sized value-add investment proposed by a sponsor with less experience in a secondary market. In this case, an investor might reasonably be willing to take slightly less of a return in exchange for investing alongside a proven sponsor.
Flaws in the Model
There are a few challenges to using the Sharpe ratio for generating risk-adjusted returns in commercial real estate.
The first challenge is that the calculation generally uses backwards-looking data. Investors rarely have the foresight to know how an individual asset will perform over a 10-, 20-, or 30-year period. Instead, prospective investors must evaluate how that sponsor’s overall portfolio has performed over a period of time since the commercial development project in question may just be getting underway.
Second, and related to the point above, most risk-adjusted returns are calculated using real estate indexes as a benchmark to analyze the risk and returns of commercial real estate. However, investors seldom hold portfolios that are as well diversified as the indexes, and the risk of return characteristics at the property level are not necessarily similar with the risk of returns of indexes.
Due Diligence is Critical
Rather than blindly investing based upon expected rates of return, investors are advised to dig a bit deeper. A thorough due diligence process can help commercial real estate investors truly understand a project’s risk. A few core risks to consider:
- Age of Property: The newer the property, the less risk associated with major capital expenditures such as a new roof or heating system. The older a property, the greater risk that the major building components will be nearing the end of their useful life.
- Market: As noted above, investing in core markets is generally considered safer than investing in secondary or tertiary markets. Individual markets also have submarkets. If evaluating two properties in the same core market, look at how similar properties have performed in that that specific submarket (e.g., how an apartment building performs in Chelsea vs. Greenpoint NYC).
- Quality of Sponsor: Before investing, evaluate the experience of a sponsor. Review their credentials, previous experience, and quality of their product. Specifically, look at whether their projects have met or exceeded projected rates of return in the past. If a project did not meet expectations, probe further to understand why and ask the sponsor to explain how they plan to mitigate this project’s risks. It is very possible that it’s “safer” to invest with a high-quality sponsor in a secondary or tertiary market compared to a novice sponsor looking at a deal in a core market.
Mitigate Risk via Diversification
Just as investors are advised to diversify their portfolio of stocks and bonds, the same is true for those who invest in commercial real estate. Just as you wouldn’t want to invest in all high-risk stocks and speculative companies, you don’t want to invest in all high-risk commercial real estate opportunities. Yes, the returns may end up being higher—but you stand to lose more in the process if things don’t go according to plan.
Instead, real estate investors should diversify their portfolios with properties of varying degrees of risk. This might mean investing collectively (through crowdfunding or otherwise) in a Class A project while investing with a highly-experienced sponsor doing a Class C value-add deal in a secondary or tertiary market. The end goal should be to achieve superior risk-adjusted returns, which requires diversifying in a way that minimizes risk and maximizes returns – no easy task, and one that even the most sophisticated investors grapple with over time.