Risk adjusted returns – not all investments behave the same - MBC REI

When comparing investment opportunities, it is very tempting to just look at one of the common metrics, in particular IRR, and pick the investment with the best projected return.

While there is some value in comparing these numbers, you really need to consider other factors about the deal in order to have a fair comparison. The two most important factors to consider are the relative risk of the investment and the tax implications of the deal.

In this article, we focus on comparing the risk across deals. For simplicity, I will equate the risk of the deal with the potential range of the return when the underlying assumptions change.

One important thing to recognize in a deal is the risk of a complete loss of your investment. While this risk is never 0%, it is usually small. However, that isn’t always the case. The more leverage that is taken on, the more work required to generate cash flow, etc., the higher the risk that your entire investment will be lost. The chances of losing your investment, not just getting a lower rate of return, needs to be factored in to your investment decisions since you would want to invest less of your portfolio into a deal with a higher risk of complete default than one where the risk was primarily a lower return – even if the upside potential was also higher.

Usually, deals that offer returns over 10% are riskier (broader range of possible outcomes) than ones that advertise lower returns. These deals typically rely on high leverage to improve the investor returns, require implementation of some underlying value-add strategy to change the fundamental income profile of the property, and make optimistic assumptions about the sale of the property. While these strategies can lead to higher investor returns if everything goes well, they can also negatively impact the returns if things do not go as planned.

Leverage is one of the advantages real estate investing has over other asset classes, such as stocks and bonds. It is possible to have someone lend you the money to make a purchase and then pay them back from the cash flow generated by the property. If the interest rate on the loan is low, then buying a larger property with the same cap rate allows you to provide higher returns to the investors (if I can get a mortgage at 3% while the property generates 7%, the 4% difference goes to the investors). However, if the cash flow is not sufficient to pay back the loan, the lender can foreclose on the property and the investors get nothing. This can happen either because the payments on the loan increase, because the loan is variable rate or expires, or because the cash flow for the property decreases (see examples in a previous post [1]). The higher the loan amount (and thus the loan payment), the more likely the cash flow will be insufficient to cover it. In addition to the amount of leverage, it is also important to consider factors such as the type of debt (variable or fixed rate, short or long term) and projected changes in the cash flow (rent increases, vacancy numbers).

Performing a “value-add” has become standard practice on many asset classes. The underlying assumption behind this strategy is that the new owner can do something to force an increase in cash flow. This can be anything from a complete gut and remodel of the property, to adding automation, to simply being more proactive about rent increases. The more aggressive the approach, the more likely there will be unplanned expenses that eat into the projected returns. For example, the supply chain issues we saw in 2021 that dramatically increased construction prices. The longer the approach takes to complete, the more likely that something unexpected will occur – or that inflation alone will cause costs to rise.

Finally, the calculation of IRR requires making assumptions about what will happen when the property is ultimately sold. This factors in both assumptions about overall increases in rent and expenses (and thus the net operating income) and the cap rate that you will get on the sale.

I tend to find that looking at a specific example [2], though hypothetical and simplified, helps clarify the points. For purposes of this discussion, I consider the impact of interest rates, cap rates, and rental rate increases when paying all cash (a conservative strategy) compared to taking out a loan at 80% of the purchase price (riskier strategy). In this case, the example investment is for a property purchased for $1M at a 7% cap rate. That means that the NOI for the property in the first year is expected to be $70k/yr. I ignore the transaction costs for simplicity.

If we assume an increase on our NOI of 2% per year and that we sell the property at the same cap , then the IRR if we have no debt is 8.27%. However, if we have an 80% loan on the property at a fixed rate of 7%, our IRR increases to 12.62%. This increase is primarily because the initial cash requirement is lower and our debt service stays the same while our NOI increases over time.

The addition of the loan gives us the ability to dramatically change the rate of return by changing some of the underlying assumptions. If we assume the loan rate is 6% instead of 7%, then our IRR goes up to 15.02% (a 19% increase). And if we also double the rate of increase on our NOI to 4% instead of 2%, we are now at a 19.49% IRR (a 54% increase) – while our IRR with no debt only increased to 10.00% (only a 21% increase). And finally, if we assume that we will sell the property at a 6% cap rate instead of 7%, then our IRR increases to 21.67% (a 71% increase over the original assumptions) compared to 11.08% with no debt (a 34% increase). Individually, none of these modifications appear to be major changes in the assumptions, but the end result on the projected IRR is significant. Who wouldn’t want a 22% return over an 8% return?

But the volatility moves in both directions. If we keep the 80% loan at 7% and instead of increasing, the NOI stays flat, the IRR is the same (6.55%) for both deals – but clearly, there is more risk on the property with the debt since there will need to be a refinance at an unknown rate at some point in the future. And if the rents decrease slightly, with a -1% NOI, the deal with the debt is significant worse than the all cash deal (2.55% vs 5.68%) as the debt payments take up an increasing portion of the payments. If there is additional cash required for capital improvements, as there would be for a value-add, things get even worse. If we add in $100k for capital improvements, but the rents still go down 1%/yr based on the market conditions, with no debt on the property the investors still make 4.43%, but the deal with the 80% loan ends up losing 1.48%.

As you can tell, you need to stress test the deal and evaluate how it handles variation in the original assumptions. If interest rates increase or stay the same, what happens to the cash flow? If the rent increases are at or below historical normal rates instead what is projected, does the deal still work? What happens if the selling cap rate is the same or higher than the purchase cap rate, instead of it being lower?

There is a very important difference between the investor just getting a slightly lower return and the investor getting nothing back because the bank foreclosed on the property.

If the return to investors have little variation in these scenarios, basically matching the changes in the input, then you have a relatively low risk deal. However, if the returns quickly appear and disappear based on small changes in the overall assumptions, then the deal is higher risk.

Just because a deal is high risk doesn’t mean that you shouldn’t invest in it. You do, however, need understand what you are getting in to. Higher risk deals can definitely lead to higher returns. However, you can’t directly compare the projected results of a high risk and low risk deal, since the likelihood of getting the projected returns are very different. You need to adjust the projected returns based on the risk, and account for your personal risk tolerance, before determining which deal is the better fit for you.

If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

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This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.