Risk Adjusted Returns Explained

Let’s elaborate.

In the cycle leading up to the 2008 Great Recession, banks were lending tremendous amounts of capital to commercial real estate owners. Many investors were buying properties with loans that amounted to 90% of the property’s value. In other words, in order to buy a $10 million office building, an investor only needed $1 million in equity. The other $9 million was financed.

Now, let’s say that $9 million was financed at four percent and the property generates $1 million a year in cash flow.

From an investor’s perspective, this looks like an incredible investment opportunity. Let’s say the owner pays $360,000 per year in interest. He has $640,000 remaining in annual cash flow on a $1 million investment. At first glance, this looks like a 64% return. Incredible, right?

So, were these properties really incredible investment opportunities? Maybe. But more often, investors were generating these astronomical returns through “financial engineering”. When the market collapsed, vacancies increased, net operating profits dropped, property values tumbled – and that’s how so many investors lost their shirts in their underwear! Their portfolios were so highly levered that they no longer had any equity to speak of. Instead of having double, even triple digit returns, now investors were underwater on their mortgages.

This is where the concept of risk-adjusted returns comes into play. In short, the riskier the investment, the greater return an investor should expect. And when you increase leverage, you may be exponentially increasing risk.

Evaluating risk is no easy task. Most sophisticated investors will begin by looking at how an asset performs on an un-leveraged basis. That’s because debt can be structured in many ways (and refinanced), so it’s important to know how a property performs before layering in debt service. This is the best way to compare apples to apples when considering different real estate investment opportunities.

Let’s say an investor is looking to buy commercial real estate in the Tampa area. There are a few different investment opportunities before him:

• Property ABC is a $50 million, Class A office tower. It is 90% leased. Given current cash flows, the going-in cap rate is 6.0%.
• Property JKL is a $20 million office property. It is 80% leased. The going -in cap rate is approximately about 7.5%.
• Property XYZ is a $6 million, Class C flex building, currently used as a combination of research, office and warehouse space. It is 95% leased. The going-in cap rate is approximately 12%.

A novice investor might readily jump to purchase the flex building (Property XYZ). Knowing the going-in cap rate is a good starting point, but investors should consider several other factors.

For instance, who the tenants are (credit worthy vs. not) and how many years is left on those lease terms? Flex buildings are notoriously tenanted by weak credit tenants with short-term leases. Therefore, in the above example, the 12% cap rate could evaporate overnight.

In contrast, it may be the case that Property ABC is leased to Alphabet (Google’s parent company) with a 20 year lease term. In this case, the 6.5% cap rate might be an incredibly good deal for the investor because the risk-adjusted return is much lower than the flex building.

Let’s compare that to Property JKL. The investor believes that a modest tenant-improvement allowance will help them fully lease up the property. When calculating the potential returns, the purchase price + the cost of tenant improvements (TI) and brokerage serves as the denominator. The projected net income serves as the numerator. Now, assuming we apply the aforementioned formula that the going in cap rate of 7.5% can be increased to 8.5% once fully-stabilized. That would be a very nice deal and could be the most attractive risk-adjusted return.

This is the concept of risk-adjusted returns where investors evaluate multiple factors, not just going-in cap rates, when considering various investment opportunities.

Now let’s get back to the concept of leverage by considering how debt load impacts potential returns.

It can be tempting for an investor that does not have deep pockets to lever up a commercial real estate investment. The leverage reduces the amount of equity that the investor has to come up with in order to close the transaction.

Let’s say Property ABC is purchased with 65% leverage at a 3.75% interest rate that is fixed for the first ten years. Property XYZ is purchased with 90% leverage, but in exchange for that loan-to-value ratio, the bank requires a 5.25% interest rate. The rate is only fixed for five years, at which point it floats up or down relative to the LIBOR index.

Fast-forward five years. The economy has contracted, property values have declined and interest rates have skyrocketed. Because Property XYZ is so highly levered, the interest payments (which have now increased) are eating away at the investor’s margin. The owner of Property XYZ is at greater risk because the property is so highly levered. The swings, in value and interest rates, are less likely to impact the owner of Property ABC because they have less debt (as a percentage of the loan) on the property.

In other words, the two properties that were both anticipated to have similar returns are now generating drastically different returns because of how highly levered the Class C property is in the face of a downturn. Initially, the cash-on-cash returns for Property XYZ seemed far better than those for Property ABC – but the resulting risk-adjusted returns are worlds apart.

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Investors are cautioned to always look at investment opportunities from the perspective of risk-adjusted returns. One way to reduce risk is to cap leverage to 65%-75% loan-to-value or lower. If the numbers on a deal still work, this puts investors in a good position even in the event of a market correction.