Risk-adjusted return is a common measurement in institutional investments. It compares the measurable risk – in terms of variability – against the expected return.
This measurement is easy in high-velocity transaction markets, like those for public debt and equity. You have plenty of data to compare one investment against another. However, a low velocity (thin) and illiquid market, like real estate, doesn’t have so many data points to compare.
Because real estate markets are less efficient than public securities, we need to consider other strategies for measuring risk-adjusted returns for CRE Investments.
Establish Your Benchmark
United States Treasuries are perceived, globally, to be the benchmark for a risk-free investment. These bonds have the greatest probability of performing out of all available investment opportunities. It’s also a highly efficient and liquid market, as a result.
This is a good place to start.
As an investor, you always have the opportunity to let your cash sit in a Treasury bond as opposed to investing in real estate. Therefore, choose the horizon that fits your investment strategy.
In most cases, you will look at the 3-year or 7-year Treasury. You can take the average rate of return between these two bonds to benchmark for a 5-year hold.
Treasuries don’t tell you much in the way of risk-adjusted return for CRE investments. For that, I look to establish a benchmark within my target asset class.
Some markets, like single-tenant net leased properties, are highly liquid with plenty of deals for comparison. Others require a little more creativity.
I like to look at REIT pricing for the risk-free rate. Choose a REIT that approximates closest to your strategy with respect to debt levels, product type, and execution approach. After all, public REITs are the most liquid real estate investment alternative for your free, investable cash.
Score the Risk
Real estate risk is somewhat subjective. We don’t have rating agencies that quantitatively measure risk in the same way as public securities. Therefore, we need to establish our own risk scale.
Start by scoring your benchmark on the following characteristics on a scale of 1-10 with 10 being riskiest. You may modify this list based on your risk perception, but it’s a good place to begin.
- Location
- Regional Economy
- Physical Asset
- Tenant / Guest Profile
- Revenue Stability
- Expense Structure
- Execution Strategy
- Sponsor Quality
- Capitalization
- Liquidity
Now, score the investment opportunity (subject) based on the same criteria, and add up the scores.
Compare Investment Opportunities
Risk-adjusted return is a measurement of your opportunity cost. You can either invest in the low-risk or high-risk opportunity. Either way, think about how you want your cash to work for you.
Find the percentage difference between your benchmark return and subject return. Next, find the percentage difference between the benchmark risk score and the subject risk score. With these two numbers you can establish the additional risk you take by increasing your rate of return.
For example:
- Benchmark return: 12.0% IRR
- Subject return: 16.0% IRR
- Return difference: (16.0%/12.0%)-1 = 33.3%
- Benchmark risk: 60
- Subject risk: 43
- Risk difference: (60/43)-1 = 39.5%
In this example, you are taking on 39.5% more risk to get a 33.3% higher return. It’s up to you from here whether the increased risk is worth the higher return.
This is a highly technical approach to evaluating rush-adjusted returns for different CRE investment opportunities. Most investors don’t go through this exercise for every deal. Instead, they rely on intuition. Still, I find it instructive to get a good sense of your risk tolerance when looking at different opportunities in the market from time to time.