October 20, 2023
By: Evan Polaski, Investor Relations Managing Director
As an investor, you are looking to achieve the highest possible return on your invested capital, and risk plays a significant factor in any investment decision.
Is a deal projecting a 20% return always better than one projecting a 13% return? Not necessarily. Continue reading to learn about ways to compare the risk of private real estate objectively and subjectively.
A standard risk metric in private real estate is standard deviation. When operators share only their average returns as a metric, without specific deal-by-deal return information, you are missing crucial information you need to gauge the standard deviation of their track record. For example, if a group sold 20 deals with an average 20%-year return, but half those deals yielded only a 5%-per-year return, and the other half yielded 35% annually, you would not be so confident about what you could expect of their performance.
Alternatively, if an operator showed an average 20%-year return with 18 of the 20 deals having an overall 18–22% year return, even though you should not rely on past performance as an indicator of future performance, as an investor you could feel more confident in the operator’s track record.
When assessing an investment, understanding risk is imperative. Standard deviation of returns is a solid metric to use alongside the operator’s overall track record.
More subjectively, there are other ways you can assess risk with private real estate markets. These are fairly simple to understand, but certainly take a little more work in practice. The three main categories can be lumped into assets, markets, and the operator.
Starting at the Operator Level
What is the operator’s experience?
From the founders to the department heads, there should be a deep bench of experience throughout the company. Assessing their combined experience through multiple market cycles in the industry can help investors evaluate risks. Operators with longer track records tend to be more experienced with their assumptions than newer operators simply because they have been exposed to more market cycles and know how macroeconomic trends can affect rent growth and occupancy rates at different income levels.
Track record is key. However, an operator’s track record can also be affected by how they manage their deals in both good and not-so-great market conditions. Therefore, performance in relation to market conditions is another risk factor to consider. Usually, operators who have been around for longer will have more of this information available for assessment purposes.
What is the structure of the investment?
Typically, private real estate is accessed through a single asset investment or a fund investment. Diversification is a proven strategy employed to mitigate risk in an investment portfolio. A real estate fund is similar in that several assets are accessible through a single investment. When you have a single investment that holds multiple assets, you are gaining diversification in your investment and thereby mitigating your risk.
How are the assets managed?
Operators that own every aspect of the operations, such as overseeing the business plan and owning the property management and construction management companies, provide firsthand insights across every aspect of the business. Through this vertical integration, an operator can create significant value for their investors and are generally able to control their own costs significantly better than those who outsource aspects of asset management.
At the Market Level
There is a saying in real estate: location, location, location. This has held true because the broader markets and submarkets of each asset can sometimes override the efforts of the operator.
What drives market demand?
When looking at a market, many factors can come into play. But ultimately, market selection can be reduced to demand. This demand focus should be driven by the tenants, that is, the ability of an operator to keep the property full and continue to see rent growth. Typically, when tenant demand is high, investor demand will be high. Thankfully, demographic demands typically don’t shift quickly, and outside of the COVID-19 pandemic, historically shifts often occur over years, if not decades.
How often are changing demographics monitored?
If the operator has a “set it and forget it” approach to market selection, your investment could be subjected to unneeded risks. Stalwart markets like Dallas, Phoenix, and Atlanta are always changing. Usually, operators that consistently—at least annually, if not semi-annually—take an objective view of the markets and identify those that show the best trends for new investments are considering demographic changes and risks.
At the Asset Level
Finally, the asset can introduce a lot of risk. Having in-demand amenities, or a business plan to add those amenities, can certainly affect tenant interest and desire to lease your property.
What is the operator’s due diligence process?
To mitigate your investment risk, your chosen operator should maintain a thorough due diligence checklist for the assets. This list should extend beyond the property lines into the immediate surroundings as well:
- Condition of roofs
- Condition of every unit
- For renovations, how many cabinets, door handles, and closet pulls
- Condition of pool equipment
- Zoning reports
The list goes on and on, including many factors outside of physical conditions. Competitive rents, new unit availability, the income and employment base at the property, and the nature of immediate surroundings are all factors you should consider when assessing the risks associated with a particular asset.
Although there is no universal way to calculate risks in private real estate, understanding where the risks lie between investment options together with projected returns and an operator’s track record should match your personal goal to make the ultimate investment decisions.
Track record speaks volumes.
Ashcroft Capital has a proven track record of success in the real estate investment industry, having acquired over $2.7 billion in assets and managing a portfolio of more than 13,000 units.
We have a strong reputation in the real estate investment industry with more than 3,000 investors, of which 65% are repeat investors. This level of trust and loyalty reflects our performance and commitment to delivering value to our investors. We manage 37 communities across Texas, Florida, and Georgia, and our performance is demonstrated through our 32% Net Operating Income (NOI) growth, 25.7% Annual Cash on Cash Return, and 22.7% Limited Partner (LP) Internal Rate of Return.
For more information on risk adjusted returns, join Director of Investor Education Travis Watts on The Passive Income Lifestyle for an additional conversation on this fundamental topic.