Many commercial real estate (CRE) sponsors—individuals or companies responsible for identifying, acquiring, and managing the property on behalf of their investment partnerships—say that they can deliver remarkable risk-adjusted returns for their investors. But what does this term mean?
One of the most fundamental financial concepts, risk-adjusted returns, is a metric that considers potential risk when analyzing an investment’s performance and rewards investors accordingly. To simplify, a higher level of risk is generally associated with greater returns for the investor.
How is risk measured?
The Sharpe ratio is one of the most-used methods for estimating risk. This metric explains how much excess return you can expect to receive in exchange for bearing the added volatility that comes with holding a higher-risk asset.
It is calculated by using excess return and standard deviation to measure reward per unit of risk. When analyzing portfolios with shared qualities, a higher Sharpe ratio is better.
Assessing the risk carried by an asset means comparing it to a suitable benchmark. For example, the risk-free rate of return is traditionally the rate of return on 3-year bonds–the shortest-dated and least volatile type of U.S. Treasury.
However, some experts don’t agree, saying that the risk-free security should match the comparable investment’s duration. For instance, using a 10-year U.S. Treasury as a baseline in commercial real estate investments may be more appropriate for comparison purposes.
It is important to remember that regardless of the benchmark used, it is merely a theoretical return rate for zero risk. Unfortunately, no such thing as zero risk exists in reality.
How are risk-adjusted returns used in commercial real estate?
The Sharpe ratio is a useful metric for assessing the historical risk-adjusted performance of an asset, with higher ratios indicating better returns. By comparing the Sharpe ratios of two CRE assets, you can measure how much volatility each purchase had to endure to achieve the excess return.
Let’s use a simple CRE example to understand how this applies in the real world. Say you were allowed to buy one of three different properties with varying expected rates of return and characteristics:
- 5% return
- Institutional-quality apartment building
- Located in a core downtown Los Angeles area
- 8% return
- Class B apartment building with 150 units
- Situated in suburban Tucson, Arizona
- 12% return
- Consists of four garden-style buildings, each with 12 units
- Located in Mobile, Alabama
If all remaining factors are equal, you might be wise to invest in Building C due to its potential 12% rate of return. However, before investing your hard-earned money into this property, remember that there is a greater risk involved with achieving such an impressive payout.
If you chart the assets on a Bell curve over a time period of 30 years, you might observe that Building A experiences only some fluctuations throughout various real estate cycles.
For example, its average return may swing by 10% in either direction, but the average is a solid 5%. In contrast, Building C’s swings might span much greater ranges, while Building B lies between extremes.
These observations are certainly possible in this example. However, generally speaking, investing in a Class A apartment complex in an established area will have less risk than investing in a secondary-market Class B building or multiple garden-style apartments (with potential value-adds) located in a tertiary location.
It’s important to note that all of these investments are okay; however, investing in a lower-quality building located within a tertiary market brings more risk than investing in newer and Class A apartment buildings that often draw attention from large investors.
Thinking beyond the surface, investors can also evaluate and compare investments with similar anticipated returns. Let’s look at this example:
- 10% return
- A value-add property proposed by a trusted CRE sponsor
- Located in a core market
- 12% return
- Similarly sized to Investment X
- A value-add property proposed by a less-experienced sponsor
- Located in a secondary market
In this situation, an investor may be willing to receive a slightly lower return in exchange for the security of investing with a reliable sponsor.
What are the limitations of the Sharpe ratio?
All this said, generating risk-adjusted returns in commercial real estate through the Sharpe ratio presents a few challenges.
The primary difficulty lies in using backward-looking data because investors typically need help to anticipate how a particular asset will perform over more extended periods (such as 10, 20, or 30 years into the future).
To get a more accurate result, you should analyze how the sponsor’s entire portfolio has performed throughout its lifetime, especially considering that many commercial development projects are just starting.
The second problem is that investors usually rely on real estate indices as a reference to evaluate the risk and returns of CRE investments. But, an investor’s portfolio will likely be as diversified as the benchmarking indices. Moreover, indices and individual properties do not share identical risk-of-return dynamics.
The importance of due diligence
Instead of investing blindly and only relying upon expected rates of return, investors should be thorough and conduct a comprehensive due diligence process to gain an in-depth knowledge of the project’s profitability. Be sure to take into consideration the following factors:
- The age of the asset – In general, newer properties have a significantly reduced risk of costly expenditures (such as suddenly needing new roofing or heating systems). In contrast, more mature buildings are more prone to the wear and tear that come with aging components.
- The market – Core markets are usually more secure than secondary or tertiary locations. Additionally, individual needs can be made up of submarkets that should be considered when comparing properties (for instance, how an apartment building fares in Hudson Yards compared to Park Slope).
- The sponsor – Before committing your money, carefully assess the expertise of a sponsor. Analyze their qualifications, background information, and the services they provide.
Investigate whether or not any previous projects have achieved higher than forecasted returns on investment in the past. If a project still needs to achieve its objectives, take the time to delve deeper.
Ask the sponsor why they did not meet their target and how they intend to reduce any risks associated with that project. In some cases, investing in a highly-experienced sponsor operating in secondary or tertiary markets is far safer compared to investing with new sponsors seeking opportunities within core locations.
Offsetting potential losses through diversification
Much like stock market investors are encouraged to diversify their portfolios, commercial real estate investors also need a good mix of assets.
Make sure to put all your investments into high-risk CRE opportunities; potential returns may be higher, but you could lose more if things go differently than expected. Investing in a combination of low and high-risk properties is often more prudent.
Successful commercial real estate investors are very good at creating well-diversified portfolios that contain properties with varying degrees of risk. For example, this might mean investing in a low-risk Class A project via crowdfunding and partnering with an experienced sponsor to invest in a higher-yield but higher-risk Class C value-add deal within a secondary or tertiary market.
Work with CRE financing experts.
If you need help evaluating a property, you may bring your project to a CRE financing company that can review it and assess its viability. Unfortunately, banks and traditional lenders often need more industry know-how to evaluate the real-world potential of CRE properties. This is why it’s often better to work with lenders specializing in funding commercial real estate projects.
Capital Investors Direct is rapidly becoming one of the most prominent commercial real estate loan placement and advisory firms in the U.S. We use a personalized approach tailored to each investor’s goals and aspirations. This targeted strategy has allowed us to exceed expectations with every client we serve.
At Capital Investors Direct, we understand that every investment opportunity is unique and has its own circumstances. Our experienced commercial real estate placement professionals take the time to carefully evaluate your requirements and develop a tailored loan structure to ensure success. We don’t just stop there, either. After funding, our team continues guiding your investment journey.
We are dedicated to providing our customers with a complete range of investment solutions for their commercial real estate finance needs.
Utilizing the most advanced financial technologies and programs (including CMBS, Life Insurance Group loans, and an extensive list of Independent Private Lenders), we provide options such as Bridge Financing, Hard Money Loans, Construction Loans, Jumbo Loans, Stated Income Loans, and Permanent Loans. So regardless of your financing requirements, you can rest assured that Capital Investors Direct has covered you.