The Key to Making Sense of Real Estate Risk-Adjusted Returns
Table of Contents
- The Key to Making Sense of Real Estate Risk-Adjusted Returns
- The Risk-adjusted Rate of Return as a Measure of Comparative Profitability
- How Risk Methodologies Affect Risk-adjusted Returns
- Treynor Ratio
- Risk-adjusted Rate of Return = (Rate of Return – Risk-free Rate) / Beta
- Sharpe Ratio
- Risk-adjusted Return on Capital
- Return on Risk-adjusted Capital
- Putting Real Estate Risk-adjusted Returns to Good Use
- Selecting Your Weapon of Choice
As you invest in commercial real estate, or CRE, it’s important to ensure that your actions generate lucrative results. Whether you’re seeking partners or only trying to shore up your personal portfolio, real numbers go a long way.
Most people have heard of return on investment, or the efficiency ratio of their investment’s net gain compared to its cost. You might not be quite as familiar with real estate risk-adjusted returns, but learning about them could arm you with more relevant insights. Fortunately, applying this complex-sounding statistic isn’t rocket science.
The Risk-adjusted Rate of Return as a Measure of Comparative Profitability
Risk-adjusted return rates are a loosely defined concept with a major role in CRE undertakings. These ratios adjust the total returns that a holding generates according to the amount of risk that said asset assumes in the same period. In doing so, they make it possible to glean a more accurate measurement for comparing different investments.
How Risk Methodologies Affect Risk-adjusted Returns
Investors can calculate their risk-adjusted returns using many different strategies that reflect how they choose to quantify risk. Your portfolio structure dictates what you define as an unpredictable factor that’s worth noting, and this impacts your chosen measurement methodology.
Many analysts and portfolio managers use overall asset volatility to gauge uncertainty. This practice figures into standard risk-adjusted return assessment techniques like:
You can calculate the Treynor ratio by starting with an investment’s percentage return, subtracting the risk-free rate of return, and dividing the difference by the asset’s beta. Higher Treynor ratios typically represent smarter investments:
Risk-adjusted Rate of Return = (Rate of Return – Risk-free Rate) / Beta
The beta is a historical quantification of a property’s volatility, typically calculated by comparing its performance to some chosen index or benchmark. The risk-free rate of return is the theoretical return rate that you’d receive from an investment that carried absolutely no risk, but most U.S. investors use the interest rate associated with three- or seven-year Treasury bills as a stand-in.
The Sharpe ratio offers a similar technique to Treynor ratios, but it uses the investment’s standard deviation in place of the beta:
Risk-adjusted Rate of Return = (Rate of Return – Risk-free Rate) / Standard Deviation
Here, the standard deviation refers to the well-known statistical measure of how much the investment’s actual rate of return varies from its mean. As with Treynor ratios, higher Sharpe ratios usually indicate less risky prospects.
Risk-adjusted Return on Capital
This measurement, also known as RAROC, may be a bit simpler for those who are just starting out with investments or lack understanding of common volatility assessments. It divides the expected return by the economic capital or the value at risk associated with the investment:
RAROC = Expected Return / Value at Risk OR RAROC = Expected Return / Economic Capital
As its name implies, value at risk is the amount of value or capital that your investment places in jeopardy. Economic capital, or risk capital, is the amount that you’ll require to cover the dangers that you assume, which may include legal, operational, market, credit and other uncertainties. Your expected return includes factors like your revenues, expenses, expected losses and the income that you derive from capital.
Return on Risk-adjusted Capital
This ratio, commonly referred to as RORAC, is similar to RAROC, and it’s becoming increasingly prevalent in banking. Instead of adjusting your capital for risk, you adjust it for its rate of return, which makes RORAC more suitable for commercial real estate evaluations where the risk is asset-dependent. Here, you simply divide net income by the amount of economic capital that you’ve allocated:
RORAC = Net Income / Economic Capital
Putting Real Estate Risk-adjusted Returns to Good Use
With so many different ways to calculate a risk-adjusted rate of return, how will you evaluate your CRE investments? There’s no universal answer, but individual investors may find certain methods more or less favorable to their portfolio growth strategies.
For instance, ratios like Sharpe or Treynor can potentially facilitate quick comparisons of prospective property assets. Given the appropriate historical data, computing betas and standard deviations are trivial mathematical exercises, so you can use these measures to put things in perspective faster. With RORAC and similar techniques, you may need to perform a more in-depth discovery process to determine how much you’ll spend on activities like facility upkeep, legal compliance and routine operation. On the other hand, this data might already be available if you’re analyzing the performance of a property that you currently own.
Selecting Your Weapon of Choice
Is one methodology better than another? Once again, it’s usually situational, because there’s ultimately no universal measure of risk. As a perceived variable, the amount of risk that you incur is highly dependent on your situation and CRE goals.
For instance, purchasing your first retail center to rent out to tenants may be far more uncertain for you than it’d be for an investor who already possessed a few years of experience managing similar holdings. Factors like the size of your debt, trends in the market that your prospective property serves, material deficiencies and the age of critical building assets, such as habitability systems or wiring, can also impact risk. These circumstances will affect not only your assessments but also those of any backers who fund your investment activities.
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