You are with your financial planner, talking about different ways in which you can boost the power of your investment portfolio. Then he or she throws out the term “risk-adjusted returns” when asking about investment decisions.
If you are scratching your head about risk-adjusted returns, tell your financial planner you will get back to him/her. Then, read this article.
What It Is?
A risk-adjusted return is the rate of return you’ll expect to receive from your investment, relative to the risk you’re taking. Because investors like to be rightly compensated for the amount of risk they may be taking on, risk-adjusted return provides an avenue for determining whether or not a high risk investment, or even a low risk investment, is worth the potential payout.
The only problem? Risk is difficult to quantify, and is relative to each investor depending on his or her investment goals. In addition to this, it may not be apples-to-apples when comparing across asset classes, or even private versus public securities. There are, however, a few financial metrics that one could use to help draw conclusions about which is riskier.
When it comes to investments such as fixed-income, equity, derivatives and others, there are a few standard approaches one may be able to take to determine the investment’s projected return, based on calculations, such as Sharpe, Treynor and Jensen’s Alpha. But determining real estate’s risk-adjusted returns requires a different approach.
Determining Risk and Real Estate
Whether you are investing directly in real property or in a pooled investment vehicle, such as an LLC or Delaware Statutory Trust (DST), determining risk, and the adjusted returns, is a judgment call. Rather than specific calculations, you, the investor, first need to determine your investment risk tolerance, based on variables such as your age, lifestyle, and retirement goals. Once this is determined, you can move on to more deal specific risk tolerance, that includes sponsorship, debt, capitalization rate, tenant, lease-up/lease roll, geography and product type.
Additionally, there are various levels of risk among the real estate investment profiles listed below.
Core. Relatively stable assets, best in class, in primary markets and central locations, with creditworthy tenants and high occupancies.
Core-Plus. Many of the same characteristics as core assets, though might have exceptions that create extra risk including age/asset condition, lower credit tenants, less-than-stellar location.
Opportunistic. May require complete turnaround; ground-up development, can have financial distress, high vacancies or structural problems, a business plan for asset improvement necessary.
The Returns Fallacy
You probably realized that not all real estate returns are created equal. If so, congratulations - you don’t believe in the “Returns Fallacy.” The Returns Fallacy suggests all deals are equal, and the best deal is the one with the highest projected cash-on-cash return.1
Take a look at the chart below, which offers two types of property investments.*
|Asset Class||Class A||Class B-|
|Property Condition||New Construction||Deferred Maintenance|
|Average Remaining Lease Term||20 years||2.5 years|
|Target Holding Period||7 years||4 years|
|Target Investor Rate of Return (IRR)||9%||20%|
*The investments shown above are examples, and are provided for illustrative purposes only.
At first glance, it might seem as though the opportunistic investment might be the best. After all, who wouldn’t want to obtain a 20% IRR on their investment?
But that investment is, by far, the riskier one. Here’s why.
Asset Class. A Class A property may have the ability to attract a higher tier of tenants compared to a Class B property.
Property Condition. The better the asset’s physical condition, the less chance of unforeseen capital expenditures being required during the course of the holding period.
Tenant Profile. The investment-grade tenant is more likely to remain in occupancy, and current on its rent, over the full term of the lease.
Location. Generally speaking, primary markets are considered more established and therefore less risky than secondary markets, which may be more “up and coming”. Within the market itself, an “A” sub-market location is considered to be less volatile than a “B” location.
Loan to Value. All else being equal, the lower the debt, the lower the probability of loan default, and/or foreclosure. As we’ve previously written about, debt magnifies returns in both directions.
Occupancy. The risk is greater if more leasing is required to achieve projected returns. Location in a sub-market with high occupancy may make it easier to find tenants and lease-up a property. Additionally, the landlord may not need to provide as many leasing concessions to tenants in a sub-market with high demand.
Average Remaining Lease Term. The longer the remaining lease term, the less frequently the landlord will have to deal with lease expirations, renewal negotiations and possibility of vacancies and incurring lease-up costs such and leasing commissions and tenant improvement allowances.
The above is not to suggest that one investment is better. It is to point out that the opportunistic venture has more risk, though the projected returns might be greater.
Highest Return = Riskier Investments
Though it would be great if all investments provided high risk-adjusted returns, this doesn’t happen in the real world. The highest targeted IRR might not offer you the best returns once you consider the amount of risk in those projected returns. As such, it’s up to you, as the investor, to determine your individual investment risk tolerance, then determine whether a specific investment fits within your risk tolerance and has a place in your overall investment portfolio.
The general investor expectation is that higher risk investments require a higher expected (projected) return. However, in the real world, risk and return do not always have a perfect correlation. Realized 1031 can provide guidance on real estate risk factors, to help you determine which investments may be appropriate considerations for your portfolio and then help you to potentially maximize risk-adjusted returns within the confines of your personal risk tolerance and investment objectives. Contact Realized 1031 at 877-797-1031
- CrowdStreet. The Returns Fallacy: Contemplating Volatility in Real Estate Targeted Returns. January 11, 2017.