RISK ADJUSTED RETURN

The Risk Adjusted Return (RAR) allows property investors to compare investment opportunities with different return and risk profiles. This investment performance measure, which is also often referred to as the Sharpe Ratio is calculated as follows:

Risk Adjusted Return = (Expected Return – Risk-Free Return)/ Risk

This formula actually calculates the expected return in excess of the risk-free rate per unit of risk. In this formula, expected return is the return expected to be achieved by the particular property investment, the risk-free return is the return achieved in the marketplace by risk-free investments and risk is the perceived risk for the particular property investment opportunity. The risk-free rate typically used for property investments is the 10-year T-bill rate.

Assessing the risk of a particular real estate investment is not easy and is usually done through Monte Carlo simulations of random future cash flows of the property based on a set of plausible ranges for the major income and expense items determining such cash flows.

The Risk Adjusted Return is often used at the asset class or property-type level, where historical return data can be used to calculate average historical returns, which are considered to represent the expected return for each property type, and their volatility (standard deviation), which is considered to measure the risk associated with such returns. In such a context, the RAR formula can be written as:

RAR = (Average Return – Risk-Free Return)/ Standard Deviation

Notice that the average return for a property type and its standard deviation may vary depending on the historical period that is used to calculate such measures. For example, using the data for office returns published on the site of the National Council of Real Estate Investment Fiduciaries (NCREIF) for the period 1990-2010 the average return is 6.4% and the standard deviation is 11.4%. However, if we use the period 2000-2010 for the calculation of the same measures, the average office return comes to 7.7% and the standard deviation to 12.2%.

Calculation of risk-adjusted returns for the four major property types for the period 2000-2010, points to retail as the property type with the highest RAR and office the property type with the lowest RAR.

Search Our Over 500-Page Website!

Custom Search

Real Estate Investment Mathematics
MADE SIMPLE!
Download RISK-FREE all these formulas Now!
Internal Rate of Return(IRR)
The 3 Formulas for Modified IRR (MIRR)/Financial Management Rate of Return (FMRR)
Potential Gross Income Multiplier (PGIM)
Potential Gross Income
Effective Gross Income Multiplier
Effective Gross Income
Net Income Multiplier
Net Operating Income
Overall Capitalization Rate/Income Return
Capitalization Factor
Band-of-Investment Formula for Estimating a Market/Required Capitalization Rate
Theoretical-Approach Formula for Estimating a Market/Required Capitalization Rate
Appreciation Return
Total Return
Return on Total Capital (ROR)
Return on Equity (ROE)/Cash-on-Cash Return/Equity Dividend Rate
Before Tax Equity Cash Flow (BTECF)
Equity Investment
Loan Amount
Debt Service
Mortgage Constant
Payback Period
Breakeven Occupancy
After Tax Cash Flow (ATCF)
Taxable Income
One-Period IRR
Income Tax Payment in Association with Income Producing Property
Capital Gains
Formula for Cash Flow for Last Period of Analysis
Future Resale Price
Annual Rental Income of Occupied Multi-Tenant Property
Multi-Period Lease Rate Growth Formula with Intertemporally Variable CPI Forecast
Multi-period Lease Rate Growth Formula with Constant CPI Forecast
Present Value (PV)
Net Present Value (NPV)
Profitability Index
And more….