When You Evaluate Investment Returns, also Consider Risk
By Scot Eisendrath, Managing Director
The phrase “risk-adjusted return” is defined by Investopedia as “the profit or potential profit from an investment that takes into account the degree of risk that must be accepted in order to achieve it”.
Understanding the risk/return relationship is a key to successful long-term investing. As an example, commonsense tells you that the interest that you would earn from a treasury security backed by the U.S. government should pay a lower rate of interest than what you would earn from a corporate bond, assuming similar maturities. This is because a treasury security is considered a risk-free asset (in theory, the U.S. government would never default), and the income stream from a corporate bond is riskier because there is a chance the issuer may default, meaning they may not be able to pay the interest or repay the bond principal at maturity. To compensate an investor for buying the corporate bond, with its riskier cash flow stream, a premium rate or “risk premium” needs to be offered.
While most investors understand the concept of risk premiums and risk-adjusted returns, many don’t properly respect risk or demand a sufficient return premium for the risk they are taking on, especially during bull markets. But, risk is always present, as we are reminded during bear markets or challenging economic cycles.
The past 18 months are a great example. Investors piled into riskier assets, such as technology stocks, cryptocurrencies and SPAC’s, and they may have disregarded or discounted the risks associated with the potential returns of these more speculative investments. As the Federal Reserve began aggressively raising rates over the past year, these more speculative sectors saw the greatest decline in values.
The same concept of risk-adjusted returns also applies to real estate investing. The risks of a potential real estate investment need to be weighed in relation to the potential returns. Often, investors do not properly consider the risk factors when evaluating prospective real estate opportunities. Friends and family members frequently say “Hey, what do you think of this real estate investment that I’m considering?” They may send me a detailed offering memorandum and ask for my input, or it may be an informal conversation at a social event. Below are a few of the high-level questions and risks that I suggest you consider – along with potential returns – when evaluating a potential real estate investment:
- Invest with good people – For me, the most important thing is the person or team (called the “sponsor”) that you are investing with and putting your trust in. Do you have a personal relationship with them, or do you know someone that has a relationship? Not a deal killer if you don’t, but if you or someone you know has a relationship with the sponsor, and it’s been a positive one, this can provide reassurance that you are dealing with reputable people. How long have they been in business? What’s their track record, specifically in the property type and geography of the potential opportunity? Are they well capitalized? Do they have meaningful “skin in the game” – equity invested in the fund or property alongside other investors? These factors matter less in good times but can be very important if there are bumps in the road or things don’t go exactly according to plan.
- Deal terms need to be fair – Going hand in hand with the quality of the sponsor are the terms of the deal between the limited partners and the general partner or sponsor. Are the fees excessive or are they reasonable? Sponsors may charge acquisition fees, disposition fees, construction management fees, asset management fees and refinance fees, to name some of the more common fees. Is the “promote” or carried interest (the percentage of profits which go to the sponsor) reasonable? Sponsors need to earn reasonable fees and promote – that’s why they are in the business. It’s unreasonable for a sponsor to earn excessive fees or higher than a reasonable promote percentage. These increase the risk and lower the return for the limited partners – a double whammy! If I see an investment package where there are excessive fees, or the sponsor is asking for, let’s say 50% of the profits, the investment is dead in the water for me. Deal terms and quality of sponsor are closely linked – I rarely see a reputable sponsor asking for excessive fees or more than their fair share of the profits. There is never a deal that is so “juicy” or a sponsor that is so good at what they do that should warrant excessive compensation for the sponsor.
- Consider the property type – I try not to be too negative on particular property types, but you could probably show me any office or retail investment opportunity today and I’m a pass. In my opinion, the risks don’t warrant potential returns, and many investors don’t understand this. I know that many times the “prospective or forecasted” investment returns may be higher for a retail or office investment opportunity than for other real estate product types, but that is because you are taking on significant risk to hit those returns – and there’s no assurance they will be achieved. The target returns for a multifamily or industrial acquisition are likely lower, but that is because they come with meaningfully less risk. It’s hard enough to achieve success over the long-term with real estate investments, but wouldn’t you rather have tailwinds than headwinds? Office and retail are beset with headwinds today. For example, hybrid work lowers demand for office space and internet shopping reduces demand for brick-and-mortar retail. Conversely, a severe shortage of rental housing combined with high home prices and mortgage rates drives demand for multifamily properties. Multifamily offers a significant margin of safety while things have to go really well for an office or retail investment to succeed.
- Location, location, location – One of the key components of value creation in real estate investing is demand and the resulting rent growth. It’s straightforward to understand what the main drivers for demand are and where the subsequent rent growth comes from –they’re population, income, and employment growth. More people with good jobs earning higher wages translates to greater demand for real estate. If you are investing in a growing area, you will typically have these components. Of course, you will also normally have more supply in growing areas, which also needs to be weighed into the risk versus return equation.
- Not all financing is the same – Financing risk has been highlighted by the recent rapid rise in interest rates. Of course, a fixed rate loan is preferred over a floating rate loan because interest rate risk is taken out of the equation, but in some cases floating rate debt is appropriate for the circumstances (i.e., a property with a big turnaround, either through renovations, leasing up significant vacancy, or other heavy lifting). That said, because of the higher risk with a floating rate loan, the investor needs to be compensated with higher potential returns. The biggest red flag for me with financing is a high loan-to-value ratio – there is a high level of risk with acquisitions financed with high initial leverage. We are tracking one recently foreclosed multifamily property that was financed with a shorter-term adjustable rate mortgage at 90% loan-to-costs at acquisition. Ouch! What could go wrong?
- Read the fine print (pro forma assumptions matter) – Sponsors are trying to forecast the future, which is not an easy job. You can read research reports and confer with brokers, property managers and other consultants, but you are trying to look into the future and there’s uncertainty – particularly if you’re looking out many years. In any case, a sponsor should be reasonable with their pro forma assumptions and not overly optimistic. The assumptions in a pro forma go hand in hand with the projected returns. I’ve seen pro forma analyses with conservative assumptions and what may be considered lower returns, and pro forma analyses with aggressive assumptions and higher returns. The killer for me is aggressive assumptions with low returns! Look out for high market rent growth, a large reduction in operating expenses, and low residual capitalization (cap) rates – assumptions that may be warranted, but also may justify requiring higher returns to take on the additional risk in executing the business plan.
These are just a few of the factors that I focus on to evaluate potential real estate investments and weigh the risk and return profile of an opportunity. Many of these principles also apply to other types of investments. I hope these tips help you as you consider potential investments.
Scot Eisendrath is Managing Director of Pathfinder Partners. He is actively involved with the firm’s financial analysis and underwriting and has spent more than 20 years in the commercial real estate industry with leading firms. He can be reached at email@example.com.
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