Evaluating A Risk-Adjusted Return: Why A Higher Projected Return Isn’t Always The Best Option
Most real estate textbooks share a list of investment rules that typically follow a similar pattern:
1. Don’t lose money
2. See Rule 1.
Easier said than done. Or is it? I believe it’s possible to systematically reduce risk in real estate investing and along the way find opportunities to increase returns.
I was recently listening to a real estate professional speak about a persistent issue they are trying to solve: The projects with the highest internal rates of return (IRRs) that syndicators post on their crowdfunding platforms tend to get the most funding from small-time investors. On the surface, this makes sense, as investors are attracted to the prospect of a large return.
However, there is a much more important, yet much more difficult, metric investors should solve for: the risk-adjusted return. What the astute investor is looking to understand is how much underlying risk is involved in producing a certain return. Targeting a desired return is typically easy — the bigger the better. Quantifying and understanding the associated risk of producing that return is much more difficult.
Here are a few items to consider in your risk analysis:
• Geography: Where you are investing has a significant impact on risk. Are you investing in a top-tier, global city like New York or a tertiary market where the welcome sign says “Population 2,723”? Different markets offer varying levels of liquidity and the breadth of product type available. Thousands of investors comb New York real estate investment opportunities every day, and many can have different opinions of highest and best use. The small-town warehouse might only be able to be a warehouse, and it might have only a few possible candidates for buyers — and few potential tenants, for that matter. Geography plays a very important role in mitigating risk because it can dramatically improve liquidity, availability of tenants, options for product type and more.
• Debt: Increasing debt typically increases risk. Debt is great when it works, and disastrous when it doesn’t. Bankruptcies rarely happen with no leverage, so beware of high leverage that can be used to engineer a higher return profile. An opportunity with a high return but laden with high debt can present the investor with a low risk-adjusted return.
• Asset Class: The type of real estate you own can have a significant impact on your risk profile. Apartments are typically low risk — everyone needs somewhere to live, and in many cities, the cost of owning a home is prohibitively high. Conversely, hotels can feature a higher risk profile — if the economy turns, business and pleasure travelers decrease spending, and hotels have to immediately react by dropping pricing. (Note that the opposite can also be true: In a rising market, a hotel can increase prices very quickly. A hotel “lease” is nightly, and they can therefore reset pricing almost immediately.) Asset class can play a significant role in the amount of risk inherent in an investment opportunity, and the investor needs to be aware of where the asset class sits on the risk spectrum.
• Simplicity: Risk can often be a function of the number of moving parts. Buying a warehouse that needs a fresh coat of paint is significantly less risky than a hillside ground-up development. The ground-up development could include both construction risk and its earlier-stage cousin, entitlement risk. Construction and entitlements host a variety of risks that include being on budget, being on time, actually being able to build what you hope for, liability and much more.
• Circle of competence: Knowing your asset class and geography block by block certainly helps reduce risk — understanding who owns what asset and why, what construction type is predominant, what the local trends are, etc. So how do some firms invest across an entire state or nationwide? They have expanded circles of competence. One way to assist with your circle of competence is to bring in skilled and/or local partners. Real estate is often a team game, and by partnering with local experts, you can expedite your knowledge of a market and circle of competence, thus reducing the risk associated with your investment.
• Informational advantage: You may know about a new highway interchange, a major new tenant moving into in a nearby office building or a new transit line proposal that the bulk of the population does not. Real estate is local, and you may have an informational advantage that can reduce risk and improve returns. Networking and hustle — talking to as many influencers and stakeholders as possible, combing through available information, and being diligent with follow-ups and reminders — are often key ingredients that can provide an informational advantage. Often, public information will be available, but the timeline for execution is far enough out that other buyers haven’t paid attention and acted on the potential implications. This is where you can be an early investor in what could turn out to be an evolving submarket opportunity.
Balancing risk and return is key to any real estate transaction. While a return is often measured quantitatively, it’s the qualitative aspect of risk that makes it more difficult to evaluate. While the above is merely a short list of the many types of risk in real estate, it can serve as a starting place for assessing the risk-adjusted return profile for your next real estate investment.