As a commercial real estate investor, you want to maximize the performance of your portfolio while minimizing the risks. But how do you measure the risk and return of your commercial real estate portfolio? In this article, we will explore some of the key concepts and methods that can help you evaluate your portfolio and make informed decisions.
Risk and return are two sides of the same coin in commercial real estate investing. Risk refers to the uncertainty and variability of the future cash flows and value of your properties. Return refers to the income and capital appreciation that you earn from your investments. Generally, the higher the risk, the higher the expected return, and vice versa. However, risk and return are not always proportional, and different types of properties and markets may have different risk-return profiles.
To measure the risk and return of your commercial real estate portfolio, you need to use some risk-adjusted return metrics that account for both the level and the volatility of your returns. These metrics include the capitalization rate (cap rate), which is the ratio of the net operating income (NOI) to the property value, indicating the annual return on investment for a property, assuming no debt and no change in value. A higher cap rate implies a higher return, but also a higher risk due to a lower property value relative to the income. The cash-on-cash return (CoC) is another metric, which measures the ratio of the annual cash flow after debt service to the initial equity investment. This indicates the cash return on equity for a property, taking into account the leverage effect of debt. A higher CoC means a higher return, but also a higher risk as it implies a higher debt burden and interest expense. Lastly, the internal rate of return (IRR) is a metric that shows the discount rate that makes the net present value (NPV) of all the cash flows from a property equal to zero. It indicates the annualized compound return on investment for a property, taking into account both the income and capital appreciation. A higher IRR means a higher return, but also a higher risk as it implies greater sensitivity to changes in cash flows and value.
of note: exit cap rate - a forecast on future markets; those who bought properties in the mid-4% cap rate environment within the past few years suddenly find themselves in a mid-5% cap rate environment have lost value on paper. If they were high on leverage; their Lender will scrutinize the mortgage covenants. IRR - a reminder that it is a measure of time value, the longer the hold period the lower the IRR. Is it a bad thing; certainly not for a long-term horizon; but for a Fund seeking higher returns to meet their prospectus materials; it certainly can be a blemish that hurts the next fund raise. In real estate, everything is relative; its the underlying asset type in a great location that will determine success in the long run.
In order to reduce the risk and enhance the return of your commercial real estate portfolio, diversifying and allocating your assets across different property types, locations, and strategies is essential. Doing so can help you minimize exposure to specific market shocks and cycles that may affect one property type or location more than others, as well as capture the benefits of different risk-return profiles and correlations among different property types and locations. Additionally, it can enable you to align your portfolio with your investment objectives, risk tolerance, and time horizon. To diversify and allocate your portfolio, you must analyze the historical and expected performance, volatility, and correlation of different property types and locations. Additionally, you must utilize optimization techniques to identify the optimal mix of assets which maximizes your return for a given level of risk or minimizes your risk for a given level of return.
In the current climate of acquiring real estate I advocate going against the grain and investing in the office sector where I am seeing pricing at 25 cents on the dollar and strip centers where you can vertically subdivide the asset and sell the anchor credit tenants leases for more than the cost of the acquisition. To buy anything at a cap rate is insane because no one knows the bottom of the valuation in this marketplace. There will be 60 plus percent foreclosures on the office side of the marketplace so what happens to the banks that lent the money and the cities tax roles. We are still heading into a crisis.
For the individual investor seeking Diversification- Aside from working with top operators with a strong track record of performance, portfolio diversification through different markets the sunbelt vs the midwest, different assets (Multifamily, Industrial, Self-storage), Single asset vs Fund approach, and even different asset classes within assets like Class A, vs Class B or C for different amounts of renovation or lift to the asset to meet the strategy of the operator.
Periodic monitoring and rebalancing of your commercial real estate portfolio is essential for measuring risk and return. This practice can help you track the performance, volatility, and correlation of your portfolio against your expectations and benchmarks. It can also identify any deviations or changes in your portfolio composition, risk-return profile, or market conditions that may require adjustments. To rebalance your portfolio, you need to collect data on its performance, valuation, cash flow, leverage, and market trends. Then you should use decision rules or models to determine when and how to adjust it in order to maintain your desired risk-return balance and alignment with your investment objectives.
The final step of measuring the risk and return of your commercial real estate portfolio is to report and communicate your portfolio results and insights to your stakeholders, such as partners, lenders, or investors. This can help you demonstrate your portfolio performance, risk management, and value creation to those stakeholders, as well as provide transparency, accountability, and credibility. To do so effectively, you should prepare clear, concise, and consistent reports and dashboards that highlight your portfolio metrics, analysis, and recommendations. You also need to use various channels and formats to deliver your messages effectively and efficiently in order to solicit feedback, input, and support from your stakeholders.
One very important detail to not overlook in formulating opinions above and beyond the data; speak to your management team on asset performance; they're the ones with the boots on the ground who communicate with the tenants and truly have their fingers on the pulse of the day-to-day operations.
Concerning Mark-to-Market valuation in private real estate investments. MTM valuations are used to provide investors with an accurate and up-to-date assessment of the value of their investments. Unfortunately, some fund managers fail to adjust their statements to provide details about the value of each property investment and their impact on NAV. This failure arises from lack of timely assessments or methodologically wrong ones. This promotes distrust in this asset class.