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What are Real Estate Risk-Adjusted Returns?

Updated: May 7

A risk-adjusted return is a measure that contextualizes performance according to the level of risk associated with an investment.

This is a common term in the investment world, especially concerning the discussion of equity and fixed-income performance which is derived using the following equation:

Risk-adjusted return on Capital (RAROC) = Expected Return / Value at Risk

Real estate does not offer the same method of engineering analysis or measure risk in the same way that can be done in securities analysis. However, the concept of continues to be applied to the performance of real estate investments. The first step for investors is to start with the core concept of risk-free return, which is the notional rate of return for zero risk. In the real world, there is no such thing as zero risk, but the closest we get to it in the U.S. The Treasury, given that the United States should default on its borrowing obligations so that the investor does not receive the promised rate of return.

The second part shows how plotting the performance side of the chart is the easy part; it's the risk side that is nuanced. Therefore, the most effective way to compare competing investment opportunities is to start by aggregating risk elements to estimate these elements. To start estimating risk, investors need a basic understanding of the sources of risk in a real estate investment. Outside of real estate, risk-adjusted yield calculations are available to help determine if investors are extracting the highest possible gains with minimal risk involved.

Different methodologies exist to arrive at a precise number or ratio, including popular risk-adjusted performance measures. In commercial real estate, investors assess the perceived risks. It is subjective and dependent upon the individual investor's tolerance for the types of risk in a transaction.

Ideally, investors are seeking real estate investments that provide greater returns for the same amount of risk, or the same returns for a lower risk final score, be careful how the risk can change, and often decrease, in each investment opportunity as the transaction unfolds. For example, through due diligence processes, sponsors learn a lot about targeted procurements.

If a sponsor becomes aware that a roof or heating, ventilation, and air conditioning system requires replacement, calculates it proforma, and can take advantage of this knowledge to obtain a reduction in the seller's price, then the investment simply went down in risk with maybe little or no impact on the IRR. Hence, the risk-adjusted return just improved, Investors would need to balance risk and return to achieve optimum risk-adjusted returns.

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