Measurement of Profitability
The term ‘risk-adjusted return’ is often bandied about when real estate professionals discuss investments in the market. Investors may be familiar with the term as it relates to equities and fixed income, but those newer to real estate could be wondering how risk-adjusted returns apply to the sector and how they might affect their investment decisions.
‘Risk-adjusted return’ refers to the measurement of profitability on an investment that weighs the return of that investment against the risk in producing the return. It is a metric that investors can utilize to determine if the investment measures up to their level of risk tolerance and can be very useful in real estate investing.
When applied to equities and fixed income, risk-adjusted return on capital is equal to the expected return divided by the value at risk. In real estate, risk measurement looks at several variables, and it is used to demonstrate that investments with a higher degree of risk can often produce a greater return than those with a lower degree of risk.
In Real Estate Investing
Most multifamily investments with a lower degree of risk will produce internal rates of return (IRRs) of 12 or 13 percent; that said, a higher level of return can be achieved when risk is mitigated through a well-tested strategy.
For example, at Trion, our goal is to deliver outsized returns without taking outsized risk. The first part of our strategy involves making money on the purchase—buying at a favorable basis, often off market, in strategic locations.
We typically mitigate risk by investing in Class B or C product in high-growth submarkets that are attracting new residents and industry. This often includes assets that are under legacy ownership that has not kept the property current and up to par with what is happening in the marketplace— and as a result, have not experience the same rent growth.
Then, we execute a deep renovation of the property, creating further upside and a product that is superior to other Class B apartment properties in the area. This allows us to achieve higher rent and/or optimize our NOI through reduced vacancies and increased renewals, ultimately increasing the value of the asset for our investors.
By operating this way, we increase investors’ risk-adjusted returns, working smartly to minimize risk while producing above-average returns.
While there is a degree of risk in any investment, the risk of remaining in the ‘safe’ zone of only striving for average IRRs is that investors will look elsewhere for greater returns. It’s an example of how not taking a risk is the most dangerous thing an investment manager can do—and how it can reduce returns for multifamily investors who want higher yields from their investments.
Before investing in real estate, determine if your real estate manager is savvy about raising your risk-adjusted return while outperforming their competitors. It is a smart way to vet your investments and increase IRR in the real estate world.