How do you calculate risk?
It can be difficult to calculate and compare risk; after all, no investment is risk free. So the goal is to find the investment with the lowest perceived risk possible, which in most cases is the U.S. Treasury Bond, and use that as a benchmark. A risk-adjusted return uses the return of either a 3-year or a 10-year treasury bond to compare the investment opportunities at hand, using the Sharpe ratio.
Sharpe ratio = Return of portfolio or investment - Risk-free rate of treasury bond / Standard deviation of the portfolio's excess return.
The excess return is the additional return you gain from holding a riskier investment. A higher Sharpe ratio, the better the performance of the asset in relation to the risk it carries.
How it's used in real estate investing
This metric is most commonly used when marketing an investment opportunity to investors or when professionals, such as a fund manager or portfolio manager, reviews their fund's return. It helps them look at the performance measure of the investment portfolio to determine which assets are performing the best or creating the most vulnerabilities for the portfolio.
On a more basic level, you may come across this term when reading a real estate investment trust (REIT) quarterly or annual earnings report or when reviewing a crowdfunding investment offering memorandum. Being able to understand what the rate truly means can help you make informed decisions about buying into the stock, REIT, or investment, while also helping you compare the return to other assets that may not be risk-adjusted.
While the Sharpe ratio calculation can be a helpful tool, it needs performance data to be calculated properly. Most investments, particularly new acquisitions, don't have that data to provide upfront. This means investors are left somewhat in the dark guessing what risk measure exists.
How to mitigate an investment's risk
If you don't have real data to use, the second best thing is to simply look at the investment's overall risk profile. Determine where its vulnerabilities and potential weaknesses are. Factors like supply and demand, the market the property is in, the quality and experience of the sponsor or portfolio manager, the type of property, amount of debt, and rate of debt will all play into the risk the portfolio or investment carries. Very rarely is one factor a dead giveaway, but rather it's a combination of them that increases total risk. Take these risks into consideration and use it as a variable reducing the average return by a point or two -- or more if the investment at hand seems extra risky. This will help you have a more accurate representation of the adjusted return.