The importance of risk-adjusted returns

Note to Real Estate Crowdfunding Investors: The Importance of Risk-Adjusted Returns

Joe Stampone Featured, Invest Passively 9 Comments

I was chatting with a friend of mine the other day who owns/operates retail assets in secondary markets on the west coast. He was telling me about the mis-pricing he’s seeing in core-plus real estate deals in secondary markets driven by the lack of capital targeting the space. While there are a few core-plus funds out there, they’re typically operated by institutional players who focus on primary markets, aim to write large equity checks, and have a low cost of capital. There are very few firms who can write $5M-$10M equity checks for core-plus deals in secondary markets.

The challenge is that firms who write smaller equity checks are typically backed by high-net-worth investors (through crowdfunding sites or otherwise) and it’s tough to pitch lower return deals because they don’t understand the concept of risk-adjusted returns. If investors are used to achieving 18%-20% IRR’s on value-add deals, how do you pitch a deal that is projecting a 10%-12% total return?

I anticipate this being a challenge for real estate crowdfunding sites as the market approaches the top of the cycle. For now, the deals that advertise the highest returns will continue to get funded, however investors are unable to quantify the risk and review the underwriting to determine the true risk-adjusted returns and make sound investment decisions.

I was scanning the opportunities available on crowdfunding sites and came across the 2 deals. In your opinion, which is the better deal:

Deal 1: High-quality medical office asset in a solid secondary location with quality tenant’s in-place and little near-term lease role. Projected IRR and average cash-on-cash over a 5-years hold is 12% and 7% net to investors with cash-flow out of the gate.

Deal 2: Value-add non-anchored strip retail in a tertiary location that is currently 60% occupied. Projected IRR over a 5-year hold is 21% net to investors and there is no cash flow to investors over the first 2 years.

If presented with these two opportunities, regardless of my risk aversion, I’d be far more inclined to invest my own capital in deal 1. One of my concerns with the crowdfunding space is that retail investors take the projected returns as fact, without accounting for the risk. When deals under-perform, or even worse, lose equity value, investors will learn the hard way that understanding risk/downside is key to making quality investment decisions.

If you’re investing in real estate, there are several factors that determine the risk of a deal.

  • Deal Basis: The amount you pay upfront is the main indicator of risk in a deal. Buying a deal at a great basis can overcome many potential downsides.
  • Sponsor Risk: Real estate is an operational business where the quality and experience of the operator is key to success.
  • Physical Asset Risks: How old is the property? Is there immediate or near-term capital needs?
  • Market Risk: Barriers to entry, population, income, and employment growth, localized employment etc.
  • Tenancy Risk: Credit of the tenancy, near-term lease roll etc.
  • Debt Risk: Leverage, rate, maturity etc.

Real estate is a great investment because it is highly fragmented, operational, and location and relationship-driven, enabling investors with the right relationships and analysis to discover deals with asymmetric risk-return profiles.

In a future note to real estate crowdfunding investors I’m going to dig into how fees and the waterfall structure impact returns.

  • Good one and informative too..Residential real estate is a type of property, containing either a single family or multifamily structure, that is available for occupation for non-business purposes..

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  • Sean Sweeney

    Joe, I agree 100% on investing in deal #1. Projected IRR in deal #2 is based on much higher risk. Good point highlighting risk-adjusted returns. Very important to think about.

  • Joe, you just described half my working hours lately trying to explain that in a NIRP world getting 6-8x the T10 from an existing commercial or apartment building is not going to happen unless there are serious issues.

    While I’m also with you 100% on taking deal number 1, a new (or newly increased) risk with MOB is Trump’s stated intention to end Obamacare. While there are serious problems with the current medical care system, the future impacts of unknown changes to come could disrupt the best laid plans.

  • @@disqus_Yb9e0YwsSg:disqus thanks for the comment. Do you do any passive real estate investing?

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  • Philip O’Connell

    Hi Joe,
    First time to comment, but have been reading everything on the site over the last few months. Some truly great and helpful material that I’m using and hoping to use to break into the game. On risk adjusted returns, do you have any metric that you like to use? An example would be the Sharpe ratio used for equities in the stock market, or is it more of a qualitative approach that you take?

    Cheers,

    Phil

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  • @disqus_CuI4ueEzUP:disqus sorry for the slow response time. The Sharpe Ratio isn’t used in private real estate investment analysis.

    Instead, the most important metric to me is the Stabilized Return-on-Cost and ensuring there is sufficient spread between the Stabilized ROC and prevailing market cap rates. Next, it’s looking at the various downside risks to ensure it’s properly hedged, then looking at where the value creation is coming from. The value-add should be based on marking rents to market and improving operational inefficiencies rather than assuming market rent growth.

    There’s no science behind it. It requires real estate expertise and proper analysis. Hope this helps.

  • @Giovanni_Isaksen:disqus you point highlights another risk to real estate – the unknowns! While every deal requires the manager being comfortable with some level of unknowns, if there’s too many, it may be a sign to walk away.