Understanding Risk-Adjusted Returns

What are Risk-Adjusted Returns?

Risk-adjusted returns are a financial metric that assesses the profitability of an investment relative to the amount of risk taken. In simple terms, it’s a measure that contextualizes returns by considering the associated risk—meaning that higher potential returns should come with higher risk, and vice versa. This concept is central to all types of investing, but it is particularly crucial in real estate, where market conditions, property types, and geographic locations can all influence the risk-return profile.

Measuring Risk: The Sharpe Ratio

One of the most common tools for measuring risk-adjusted returns is the Sharpe ratio. The Sharpe ratio evaluates how much excess return you receive for the additional volatility (risk) endured by holding a riskier asset. It is calculated by using standard deviation and excess return to determine the reward per unit of risk.

• Benchmark Comparison: In real estate, the Sharpe ratio typically compares an investment’s performance against a risk-free rate, such as the return on a 10-year U.S. Treasury bond. While this bond serves as a benchmark for zero risk in theory, it’s important to note that no investment is entirely risk-free in practice.
• Higher Sharpe Ratio = Better Performance: A higher Sharpe ratio indicates better historical risk-adjusted performance, meaning that the investment has delivered more return for each unit of risk taken.

Applying Risk-Adjusted Returns in Real Estate

To understand how risk-adjusted returns apply in real estate, consider the following example:

You have the opportunity to invest in three different real estate deals, each with different expected rates of return:

• Property A: 8% return, single credit tenant triple net lease, located in a core market (e.g., a Wells Fargo bank in downtown Los Angeles).
• Property B: 12% return, a Class A multifamily asset in a major secondary market (e.g., Nashville, TN).
• Property C: 16% return, a collection of Class B apartments in a tertiary market with a value-add business plan (e.g., San Antonio, TX)

At first glance, Property C might seem the most attractive due to its higher expected return. However, it’s critical to account for the additional risk involved. Properties in tertiary markets or lower-class properties generally carry more risk, such as market volatility or operational challenges. In contrast, a Class A property in a core market may provide more stable, albeit lower, returns. It’s also important to understand operational risk given the project’s business plan – i.e., a single credit tenant triple net lease deal is much less likely to have operational issues than a Class B multifamily asset that requires renovation and re-tenanting. Similarly a single property may present more risk than a diversified portfolio. The Sharpe ratio can help compare these investments by balancing the expected returns against the risk, guiding you to a more informed decision.

Flaws and Considerations in Risk-Adjusted Models

While the Sharpe ratio is a useful tool, it has limitations, particularly in real estate:

• Backward-Looking Data: The Sharpe ratio often relies on historical data, which may not accurately predict future performance, especially in dynamic real estate markets. Real estate cycles can significantly impact property performance, making it challenging to project long-term risk-adjusted returns.
• Benchmark Limitations: Risk-adjusted returns are frequently calculated using real estate indexes as benchmarks. However, individual properties or portfolios might not align with these broad benchmarks, leading to skewed comparisons. Real estate investments are often less diversified than indexes, which can amplify risk.

Due Diligence: A Key to Mitigating Risk

Before committing to any real estate investment, thorough due diligence is essential to understanding the risk profile of a project. Key factors to consider include:

• Age of Property: Newer properties generally pose less risk related to major capital expenditures (e.g., replacing roofs, HVAC systems). Older properties might require significant investment, which can impact returns.
• Market Analysis: Investing in core markets is typically (but not always) less risky than secondary or tertiary markets. Even within core markets, submarket performance can vary significantly. For example, in New York City, properties in Chelsea might perform differently than those in Greenpoint. In addition, external factors (e.g., COVID-19) may impact certain asset classes in urban areas differently than they would a suburban/rural property.
• Sponsor Quality: The experience and track record of the sponsor are critical. A seasoned sponsor with a history of exceeding return projections is likely to manage risk more effectively than a less experienced counterpart.

Mitigating Risk Through Diversification

Diversification is a fundamental strategy for managing risk in real estate investing, just as it is in other asset classes. By diversifying across property types, geographic regions, and risk levels, investors can achieve a more balanced portfolio that delivers superior risk-adjusted returns.

For example, you might invest in a stable, Class A property in a core market for consistent income, while also allocating some capital to a value-add project in a secondary market with higher potential returns. This approach reduces the overall risk of your portfolio while maintaining the opportunity for attractive returns.

Conclusion

Achieving superior risk-adjusted returns in real estate investing is not just about chasing the highest yields—it’s about finding the right balance between risk and reward. By using tools like the Sharpe ratio, conducting thorough due diligence, and diversifying your portfolio, you can make more informed investment decisions that align with your financial goals. Understanding and managing risk is the cornerstone of successful real estate investing, and it is crucial for any investor looking to build a resilient and profitable portfolio.