Quantifying Risk in Real Estate Investing
The human mind often reverts to a state of fear when faced with stressful or unknown situations. Phycologists today understand that fear is driven primarily by emotions and not by logic. One example where this is easily seen is the perceived risk of commercial flight versus automobile transportation. While many people suffer from phobias related to flight, it is almost unheard of to have a fear of riding in a car. Yet statistics show that one is about 2,000 times more likely to die in a car crash than in a plane crash. While this type of irrational fear may seem harmless, the reality is that fear holds us from our potential in so many areas of life and finances are no exception.
So, the question must be asked. What if there was a way to quantify the returns vs. risk that a given investment provides in order to find which investment will give the highest returns for the least risk? The Sharpe ratio is the metric used to answer this question with a higher value signifying a better return for the risk taken. Using the provided chart below, one can see that out of all the assets shown, commercial real estate has the best risk-adjusted return out of all of them. Its stability and the opportunity to force appreciation through value-add improvements in a predictable manner earns commercial real estate its place amongst the strongest investments available. The stock markets susceptibility to economic, political and other key events make it incredibly volatile and its lack of predictability leads many investors who are either close to retirement or simply more risk adverse to place their money in bonds and other offerings that barely surpass the rate of inflation.
In summary, all investments have some associated level of risk. The level of this risk is dependent on several things: the quality of the investment itself, the stability of the investment and the individuals who are managing the investment. A poorly bought commercial real estate asset managed by a poor manager would certainly be a risker investment than money well placed in a mutual fund with a solid track record or another type of asset. However, when making equal comparisons, commercial real estate consistently outperforms other asset classes for the amount of risk inherit to it. Its record of stability and predictability should be strongly considered by any savvy investor looking for the highest returns at the lowest risk for their money.
If you would like to learn more about multifamily real estate investing or have any other questions, please schedule a call with us here.