Comparing Investment Returns - Factoring In Risk

My syndication deals are presented to investors using IRR (Internal Rate of Return), an annualized percentage that takes into account the timing of returns. I find that IRR works best to compare across different investment alternatives. But you can't just look at a single number and decide if the investment makes sense for you. You also need to spend some time to view the return within the context of risk. 

Everyone has a different tolerance for risk and different reasons to add different types of real estate investments to their portfolio, be it a tangible asset to hedge against inflation (low risk) or a growth play to increase overall returns (high risk).

Everyone reading this makes judgments on the risks of their investments. Some undoubtedly use more intuition and less data analysis. At the end of the day, there is a place for both intuition and rigorous data analysis as risk can be very subjective. Here is a good introductory article on types of real estate investment deal risks: https://www.crowdstreet.com/education/article/top-10-real-estate-risk/

For an example, an existing single-tenant (AAA rated) NNN leased asset at a 6% IRR may be equally attractive (on a risk-adjusted basis) as a new construction retail property with a projected 25% IRR. Not to pull back the curtain too much, but in reality the 25% IRR project is very unlikely to hit a 25% IRR but has a probability distribution of outcomes, say from -100% to 50%. Whereas the 6% projected may have a 90% chance of achieving a 5-7% IRR.

How do you calculate a "risk-adjusted return"? Again, perfect information on risk doesn't exist in the real world, so you have to filter the risks down to a few key variables. In multifamily, you could use rent, vacancy and cap rate (which calculates the final investment value upon sale). But, just realize that other variables can cause a deal to succeed or fail. 

To create a robust proforma, a syndicator makes dozens of judgments about future income and expenses based on experience with investment risks. Ideally, that syndicator communicates the key risks to the investors in a balanced way. Then the investor needs to analyze the risks and make a judgment about the risk-adjusted return. To do this an investor can request a sensitivity analysis on the key variables (or do their own). A sensitivity analysis involves changing one or more key variables to get a better picture of the probable range of returns. This can be accomplished through finance software packages that employ a Monte Carlo simulation. 

A Monte Carlo simulation does thousands of calculation by changing different variables within a set range to come up with a probability distribution of possible returns - these typically will look like a bell curve with the most probable return in the middle. From these results you can calculate the standard deviation of the projected return. The higher the standard deviation (ie. the wider the range of returns), the greater the risk. If the risk is high the return must compensate the investor or the investor will look elsewhere. (For more on appropriate returns, see my prior post on the "right" return for every deal: https://www.biggerpockets.com/blogs/7617/53388-doe...)

I caution that it is rare for sensitivity analyses and/or Monte Carlo simulations to look at a true "downside" based on the possibility of a recession. In the Great Recession, many CRE equity investment returns were negative based on the asset being underwater at the end of the (expected) hold period. I guarantee that very few of the syndicators, banks or sophisticated/institutional investors ran a sensitivity analysis (or Monte Carlo simulation) that showed a substantial probability of 100% loss of equity. This is due to human nature and it reflects the same type of cognitive bias shown by the investment bankers that caused the financial crisis (see "The Big Short").

In the end, the better operators/syndicators were able to hold onto their assets by keeping nervous investors patient and extending the hold period until the asset prices recovered. During this time they may also have had to forgo fees, lend money to the deal and/or do capital calls to meet the debt service. These years of low or no returns were not desirable for investors but allowed a far better final outcome than a foreclosure and complete loss.

For further discussion on this topic and a mathematical way to calculate a risk-adjusted return to compare investment alternatives see this great article by RCLCO: https://www.rclco.com/advisory-monte-carlo-simulation