What are Real Estate Risk-Adjusted Returns?

A risk-adjusted return is a measure that puts returns into context based on the amount of risk involved in an investment. It is a common term in the investment world, particularly as it relates to discussing returns on equities and fixed income that is derived utilizing the following equation:

Risk-adjusted return on Capital (RAROC) = Expected Return / Value at Risk

Real estate doesn’t offer the same technical analytical approach to measuring risk as can be done in securities analysis. However, the concept is still applied to real estate investment returns.

The first step for investors is to begin with the base concept of risk-free return, which is the theoretical rate of return for zero risk. In the real world, there is no such thing as zero risk, but the closest we get to it is U.S. Treasuries since the U.S. would need to default on its debt obligations for the investor to not be paid the promised rate of return. To put the risk-free rate of return into the perspective of real estate, it’s helpful to align around holding periods. Given that real estate is commonly held for periods that can range from three to seven years, we can look to current U.S. Treasury yields over the same maturity dates (as of May 16, 2016), which range from 0.94% (3-year Treasuries) to 1.55% (7-year Treasuries). Therefore, it’s a reasonable starting point to take the midpoint of that range and assume that the risk-free rate of return is 1.25%.

Now that we have our risk-free starting point, every percentage point of risk beyond a 1.25% annual return incurs risk. In theory, risk and returns have a positive correlation.

Stepping out on the risk curve generally has a correlation with a higher return. For example, a low-risk core deal, such as buying an unleveraged trophy office tower in Manhattan, has the lowest returns. Each incremental step further out on the risk curve – moving to core-plus, value-add, and opportunistic investments – should produce a corresponding increase in return. For further discussion on this topic please see “Real Estate Investment Strategy: Four Categories of Risk & Reward”.

One way to interpret risk/reward is that moving out along the risk/reward line is “fair value” or the appropriate amount of added risk for the corresponding reward. If an investment plots to the right of the line, then it possesses excess risk for the offered return. If it plots to the left of the line it possesses below fair value risk for offered return.

Conversely, if you have two competing investment opportunities that possess the same level of risk but offer different returns, the superior investment will plot above the line and inferior investment below the line. Therefore, the most efficient way to compare competing investment opportunities is to begin by stacking elements of risk to estimate that piece.

To begin estimating risk, investors must have a basic understanding of the sources of risk in a real estate investment (see: “Top 10 Sources of Risk in Real Estate Investment Deals”). Outside of real estate, there are risk-adjusted return calculations to help determine whether investors are extracting the highest possible gains with minimal risk involved. There are different methodologies to come up with a specific number or ratio, including popular risk-adjusted return measures such as Sharpe, Treynor and Jensen’s Alpha. In commercial real estate, investors are making a judgment call on perceived risks. It’s subjective and depends on the investor’s individual tolerance for types of risk within a deal.

As an example consider the following two competing investment opportunities:

Now that we have two assets to compare, we then, on a scale of 1 to 10, assign a risk score to individual risk categories and sum the score to generate a risk index score. This example is simplistic as it gives each weight to each category. In addition, it is easy to challenge each category score. The point is to illustrate that it is possible to quantify risk once you have opinions on how to rate individual risk factors. Again, please see “Top 10 Sources of Risk in Real Estate Investment Deals” for more discussion on each risk category:

Based on the data above, this suggests that the retail investment provides a better risk-adjusted return. This finding can also be supported by the notion that to receive an additional 14.3% of annual return (14% to 16% IRR) you must incur an additional 21% of risk score (33 to 40). Therefore, provided you feel comfortable with the weighting and score of each risk factor, you now have a basis to claim that the office investment incurs too much additional risk for the return offered.

Now that you have an understanding of how risk and returns can vary in competing investments, you can now appreciate, as highlighted above, how the investment with the highest IRR may not offer the best risk-adjusted return. Ideally, investors are looking for real estate investments that offer better returns for the same amount of risk or the same returns for lower risk.

As a final note, pay attention to how risk may change, and often diminish, in a given investment opportunity as the deal unfolds. For example, throughout due diligence processes, sponsors learn quite a bit about target acquisitions. If a sponsor learns that a roof or HVAC needs replacement, prices that into the pro forma and is able to leverage this knowledge to achieve a pricing discount from the seller, then the investment just decreased in risk with perhaps little to no impact on the IRR. Hence, the risk-adjusted return just improved.