What Is A Risk Adjusted Return And Why Is It Important To Understand When Investing?
When investors are considering potential opportunities there are many different metrics available for comparison. Equity multiple, internal rate of return, average annual return and cash on cash return are all commonly used. While these each have their own merits, one problem they all have in common is the lack of ability to quantify the risk of a given investment. Many investors mistakenly make their investment choices solely on which offering provides the highest projected return without considering the risk that might be associated with that project.
Risk on a multifamily project can be communicated quantitatively and qualitatively. In previous articles, we have discussed metrics such as the Sharpe Ratio which quantitively shows the average returns one can expect on an investment against the standard deviation (how volatile) of that investment return. The focus of our discussion today will be the qualitative risk and some of the factors that investors and sponsors should consider.
What factors play into the risk?
While it's not feasible to make an exhaustive list of all the factors that contribute to risk on a project, here are a few that we consider when making investment decisions.
Property Class: In multifamily investing we categorize properties as A through D and sometimes add a plus or minus for additional granularity. While we have discuss this manner of categorizing properties before, the important takeaway here is that in general an A property will have less risk (but also lower returns) than a D property. At Apogee, we look for properties that are either B or C+ as we feel they provide the best balance on the return vs risk profile.
Debt Used: This point in now more relevant than other as sponsors who have bridge debt coming due are looking to refinance or sell quickly. When possible, we prefer to use long term fixed rate debt for this reason and all our projects to date have used this type of debt. If we were to use a bridge loan on a future project, we would want to provide a clear business plan outlining how we can either sell or refinance within a reasonable amount of time and that the value from the bridge debt is worth the additional risk taken.
Business Plan: This point really ties back into the previous two, but is important enough to highlight separately. A business plan that is comprised of a heavy value add project should provide higher returns than a light value add business plan which should provide higher returns than a core (already stabilized with little value add opportunity) business plan. Once again, at Apogee we prefer light value add business plans which have been the bread and butter of our portfolio thus far.
How does Apogee Capital approach risk?
Most of our investment philosophy when it comes to risk has been discussed with each of the points above. However, the thing that readers should note is that in addition to reviewing the returns on a project, they should also quantitatively consider the risks of that project and how comfortable they are with them. As a recap, we at Apogee prefer C+/B properties with light value add opportunities combined with a long term fixed rate loan product. We believe this recipe offers strong returns at a low risk point which seems to coincide with the appetite of most of our investor base.
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 check out our free ebook "Achieving Financial Freedom Through Multifamily Investing."