How Portfolio Diversification Can Improve Your Commercial Real Estate Risk-adjusted Returns
Table of Contents
- How Portfolio Diversification Can Improve Your Commercial Real Estate Risk-adjusted Returns
- The Role of Risk-adjusted Returns in Diversified Portfolio Building
- Common Portfolio Performance Measurements: IRR and EM
- IRR, EM and Commercial Real Estate Risk-adjusted Returns
- A Practical Example
- Using Real Estate Risk-adjusted Return Diversification
Investing in commercial real estate, or CRE, is about more than just picking the right properties. Successful investors ditch lucky guesses in favor of balanced portfolio management strategies that help them survive ups and downs with equal poise and grace. Diversification is a vital part of building a set of holdings whose investments complement each other to result in a lucrative overall experience.
The Role of Risk-adjusted Returns in Diversified Portfolio Building
Risk-adjusted returns are measures of asset profitability that account for uncertainty in various ways. From using investment betas to standard deviations and risk capital, these calculations reflect your holdings’ potential to generate profits in light of their potential for volatility.
Although diversification has gained a reputation as a buzzword, its pervasiveness stems from its utility. Diversification is a process wherein investors mix and match assets to achieve specific yield goals. For instance, you may invest in a combination of retail properties, multifamily residences and office facilities to offset downswings in one field with surges in the others and mitigate risks.
Diversification strategies abound in the world of CRE. Since volatility is a fact of life, investors commonly use risk-adjusted returns as starting points or benchmarks to determine which assets might work well together in unified holdings. In this manner, they can create portfolios that deliver more stable returns than their constituent elements would alone.
Common Portfolio Performance Measurements: IRR and EM
As with calculating risk-adjusted real estate returns for individual assets, you can choose many ways to track a portfolio’s return rate. Most investors take two significant factors into consideration: the IRR and the EM.
IRR, or the internal rate of return, reflects an asset’s NPV, or net present value. Although this involves an intricate formula, the main takeaway is that IRR measurements reveal the profitability of an investment within a certain time frame without getting into inflation, interest rates or other environmental factors.
IRR calculations balance individual cash flows based on when you receive them, with far-off returns receiving lower statistical weights. In general, higher IRR values denote investment projects with increased profitability, and many property holders target specific IRR ranges for their individual portfolio assets.
EM, or the equity multiplier, is the ratio of the return that you expect to the maximum amount of equity that you’ll invest throughout the asset’s lifetime. You can calculate it by dividing the total asset value by the total net equity to reveal how much of the asset’s financing goes towards debt. As an alternate take on debt ratios, higher EMs indicate greater financial leverage:
EM = (Total Asset Value + Maximum Equity Invested) / Maximum Equity Invested
The unique nature of these two measurements means that they serve distinct purposes in profitability calculations. Although both share a risk-agnostic assessment approach, ER’s lifelong outlook makes it more appropriate for evaluating long-term holdings. CRE holders who want to determine the best way to use their funds in the here and now may favor IRR calculations.
IRR, EM and Commercial Real Estate Risk-adjusted Returns
It’s certainly possible to target IRR or EM values and use these benchmarks as your sole gauge of which investment assets are worthwhile. For all of their benefits, however, these factors miss out on the true-to-life, volatility-centric nuances of CRE. Adding risk calculations to your process improves your command of individually relevant factors and grants you a better understanding of how things might work out in the real world.
A Practical Example
Consider a portfolio with three asset classes, such as a manufacturing facility, a retail center and an apartment block. Due to factors like local population migrations, the apartment block may not maintain an acceptable IRR for long, and the need to continually add new features to retain tenants could reduce its ER and net cash flows.
While the retail center might undergo losses for similar population reasons, its increased interest payouts and your business management expertise could overcome them to make it a stronger holding. The manufacturing facility’s high-demand, operating equipment and market positioning as part of a larger business network, on the other hand, could mean that it delivers even more predictable cash flows.
Although these are just hypotheticals, they illustrate how widely CRE returns vary based on the nature of the holdings in question. Most managers accept that diversification is integral to portfolio management, but instead of limiting yourself to IRR or EM calculations, using risk-adjusted returns helps you commingle properties from a shrewder perspective.
Using Real Estate Risk-adjusted Return Diversification
In the long run, understanding the unique risks of specific deals and including them in your statistical measurements are essential aspects of building a lucrative commercial real estate portfolio. Whether you decide to invest in different asset classes or focus on similar properties in distinct markets, how you choose to mitigate volatility is up to you, but you definitely can’t afford to ignore it.
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