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In real estate, an investment's return is more than just a number. While a higher return may seem great at first glance, there's more to it than meets the eye. A risk-adjusted return is often used as a more accurate way to compare and analyze a real estate investment, because it considers the relative risk of the investment as it relates to its return. If you plan to actively or passively invest in real estate, learn what risk-adjusted return really means, how to calculate it, and how it's used in real estate investing.
What is a risk-adjusted return?
A risk-adjusted return is a calculation that determines an investment's expected return while accounting for systematic risk. This ratio is shown as a percentage and takes into account general risks that could negatively impact the return of the investment, which include market risk or volatility.
Why it matters
Higher yields often come with higher risks. Risk-adjusted return is helpful in real estate because it allows the investor to invest on a risk-adjusted basis, meaning they can achieve the desired yield without compromising on their risk tolerance. For example, for an investor who has less risk aversion, it may be better to invest in a higher quality class A property in a top-tier market with an expected rate of 5% compared to a lower class C building in a less desirable market with an expected rate of 10%.
The 10% might seem like a more appealing investment, but it also carries more risk with it. Certain investments inherently carry more risks than others with variances in income, expenses, and returns because of downside volatility, among other factors. If you were to look at the performance of each asset class over time, it's far more likely that a class A investment would be able to maintain and achieve an average return closer to the initial expected yield than a class C building in a more volatile market.
How do you calculate risk?
It can be difficult to calculate and compare risk; after all, no investment is risk free. So the goal is to find the investment with the lowest perceived risk possible, which in most cases is the U.S. Treasury Bond, and use that as a benchmark. A risk-adjusted return uses the return of either a 3-year or a 10-year treasury bond to compare the investment opportunities at hand, using the Sharpe ratio.
Sharpe ratio = Return of portfolio or investment - Risk-free rate of treasury bond / Standard deviation of the portfolio's excess return.
The excess return is the additional return you gain from holding a riskier investment. A higher Sharpe ratio, the better the performance of the asset in relation to the risk it carries.
How it's used in real estate investing
This metric is most commonly used when marketing an investment opportunity to investors or when professionals, such as a fund manager or portfolio manager, reviews their fund's return. It helps them look at the performance measure of the investment portfolio to determine which assets are performing the best or creating the most vulnerabilities for the portfolio.
On a more basic level, you may come across this term when reading a real estate investment trust (REIT) quarterly or annual earnings report or when reviewing a crowdfunding investment offering memorandum. Being able to understand what the rate truly means can help you make informed decisions about buying into the stock, REIT, or investment, while also helping you compare the return to other assets that may not be risk-adjusted.
While the Sharpe ratio calculation can be a helpful tool, it needs performance data to be calculated properly. Most investments, particularly new acquisitions, don't have that data to provide upfront. This means investors are left somewhat in the dark guessing what risk measure exists.
How to mitigate an investment's risk
If you don't have real data to use, the second best thing is to simply look at the investment's overall risk profile. Determine where its vulnerabilities and potential weaknesses are. Factors like supply and demand, the market the property is in, the quality and experience of the sponsor or portfolio manager, the type of property, amount of debt, and rate of debt will all play into the risk the portfolio or investment carries. Very rarely is one factor a dead giveaway, but rather it's a combination of them that increases total risk. Take these risks into consideration and use it as a variable reducing the average return by a point or two -- or more if the investment at hand seems extra risky. This will help you have a more accurate representation of the adjusted return.
11% of the mega-wealthy swear by this investment…
The richest in the world have made their fortunes in many ways, but there is one common thread for many of them: They made real estate a core part of their investment strategy. Of all the ways the ultra-rich made their fortunes, real estate outpaced every other method 3 to 1.
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