Most commercial real estate sponsors will tout their ability to achieve superior “risk-adjusted returns.”
For investors – but what does that mean?
It’s one of the most basic premises in finance, but only a few investors truly understand it. 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 the return an investor should expect.
Measuring Risk
The most common way to measure risk is using the Sharpe ratio. The ratio describes the excess return you receive for the extra volatility you endure when holding a riskier asset.
The Shape ratio is calculated using standard deviation and excess return to determine reward per unit of risk.
To understand an asset’s risk, you must compare it to some 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. Commercial real estate often means using a 10-year U.S. Treasury as the benchmark. (It’s also worth noting that whichever benchmark is used 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 compare 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 understand better 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 in downtown Los Angeles, considered a core market. Property B is a 150-unit Class B apartment building in suburban Tucson, AZ. Property C is a collection of four 30-unit garden-style apartment buildings in Indianapolis. 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 30 years, you would likely find that Property A experiences some swings throughout multiple real estate cycles. Perhaps there’s a 10% swing in either direction, but the asset generates an average 5% return. Investment C will endure wider swings year in and year out, with Investment B somewhere between.
This example makes a lot of sense. We expect a Class A apartment building located in a core market to have less risk than investing in a Class B apartment building in a secondary market or a collection of value-added garden-style apartment buildings in a tertiary market. It is not to say that either of the investments is a bad one—but instead, there is more risk associated with investing in lower-quality products in a tertiary market than investing in a newer, Class A apartment building in a market that draws attention from international and institutional investors.
Investors can take the premises 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-added investment opportunity proposed by a reputable sponsor in a core market. Investment Y is a similarly sized value-added investment proposed by a sponsor with less experience in a core-plus market. In this case, an investor may be willing to take a slightly lower 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 time since the commercial development project may just be underway.
Second, and related to the point above, most risk-adjusted returns are calculated using real estate indexes as a benchmark to analyse the risk and returns of commercial real estate. However, investors seldom hold portfolios that are as well-diversified as the indexes and risk profiles at the property level are not necessarily similar to the risk profiles of larger indexes.
Due Diligence is Critical
Rather than unthinkingly investing based on expected rates of return, investors are advised to dig a bit deeper. A thorough due diligence process can help commercial real estate investors understand a project’s risk. A few core risks to consider:
Age of Property: The newer the property, the less risk is associated with significant capital expenditures such as a new roof or heating system. The older a property, the greater the 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 safer than 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 specific submarket (e.g., how an apartment building performs in Chelsea vs. Greenpoint, NY).
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 project risks. It is 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 be higher, but you stand to lose a lot 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 passively investing in a fund with institutional-quality real estate while investing with a highly experienced sponsor doing a Class C value-added deal. The end goal should be to achieve superior risk-adjusted returns, which requires diversifying to minimise risk and maximise returns—no easy task and one that even the most sophisticated investors grapple with over time.
National Doorstep Pickup does not provide legal or operational advice. This post has been drafted for informational purposes only, is not intended to provide, and should not be relied on for legal or operational advice. You should consult your legal and senior leaders before considering any actions.