When we speak about the quality of a given investment type, we often gravitate towards a conversation about the level of return that it provides. However, it is just as important to understand and quantify the risk associated with these returns. While this might seem difficult to do there are various ways of calculating risk and today we will speak to one of these known as the Sharpe Ratio and discuss how multifamily fares when using this metric.
What is the Sharpe Ratio?
The Sharpe Ratio was developed by William F. Sharpe who won the Nobel prize in economic science. It provides a way to compare the amount of return that a given investment provides for the level of risk incurred. The calculation is simply the return of the investment minus the risk free rate divided by the standard deviation of the portfolio's excess return.
In this equation the risk free rate is the return provided by an investment like the two year treasury and the standard deviation of excess return captures the volatility of the investment by showing how much it deviates from it's typical return. One weakness of the Sharpe Ratio is that it is based on historical returns of a given investment so a large quantity of historical data must be used to ensure it's accuracy. The higher the resulting Sharpe Ratio for a given investment, the better it's risk adjusted return.
How does multifamily fare on the Sharpe Ratio?
The chart below shows the Sharpe Ratio for various investment types including commercial real estate which would include multifamily. Here, one can see that the intrinsic value of real estate and the necessity for which it provides results in an outstanding risk adjusted return. The Sharpe Ratio for commercial real estate is in fact four times larger than large cap stocks and five times larger than small cap stocks as an example. Other investment types have Sharpe Ratios higher than stocks but produce lower returns than stocks or real estate which results in a ratio still lower than that of commercial real estate. In summary, commercial real estate provides outstanding risk adjusted returns for its investors.
There are many important considerations when evaluating a multifamily deal and we make it our mission to careful vet each of these items. If you would like to learn more about passively investing in multifamily, please set up a meeting with us through our Calendly link and subscribe to our weekly blog here.