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All About Sharpe Ratios In Multifamily Investments

Founder of Vive Funds, a unique multifamily investment firm specializing in curating high-quality assets for our investors.

Multifamily properties have been historically named as an asset that fulfills the desire for functional, clean and safe housing. Over the last decade, despite the price appreciation, the sector has done well and indicates favorability. Despite this stance in the multifamily industry, most investors look closely at the “risk-adjusted returns,” which is a basic finance parameter well understood by investors. It puts into context the returns on an investment based on the risk involved.

Measuring Risk

There are many ways to measure and manage risk in investments — standard deviation, Sharpe ratio, beta, value at risk (VaR), conditional value atrRisk (CVaR) and R-squared. Let's concentrate on the Sharpe ratio.

Sharpe Ratio

The Sharpe ratio is the most commonly used method of measuring risk. The ratio describes the excess returns you get for the extra volatility involved in holding an asset. The Sharpe ratio was developed by William F. Sharpe, a Nobel Prize winner in economic science. It was developed to help investors understand the returns of an investment related to the risk. The greater the Sharpe ratio value, the more attractive the risk-adjusted return, and the better the investment when compared with similar portfolios.

How To Calculate The Sharpe Ratio

 Sharpe Ratio  =   Return Of Portfolio - Risk-Free Rate 

Standard Deviation Of Portfolio's Excess Return

To measure the Sharpe ratio of an investment, you deduct the risk-free rate (this could be a U.S. Treasury rate of yield for one or two years) from the return of the portfolio. The standard deviation is used to divide the result. The standard deviation helps us understand how much of the portfolio deviates from the expected rate of return. 

Use Case Of The Sharpe Ratio

To better understand the use of the Sharpe ratio, we need to apply it using an example from the commercial real estate sector. In this example, you are faced with investing in three different commercial property deals with the following returns:

• Property Alpha = 10% return

• Property Beta = 13% return

• Property Gamma = 17% return

Let’s assume that Alpha is an apartment located in downtown Los Angeles. It's institutional quality and within a core market zone. Let's assume Beta is located in suburban Tucson, Arizona, as a 150-unit Class B apartment. Let's also assume that Gamma is located in Mobile, Alabama, as a collection of four Class C, 12-unit garden-style buildings. With all other conditions considered equal, you’d want to settle for Gamma with a return of 17%. But before making such conclusions, you would want to consider all associated risks with such a high rate of return compared to others.

If we were to map these investments using a bell curve over a 30-year period, we'd discover that Alpha most likely will experience some swings over multiple cycles. There could be a 20% swing in either direction, but we can settle for an average return of 10% from the asset. Beta will have longer endurance to swings year in and year out, while Gamma will be in between.

Looking at the above example, we would expect lower risk from a Class A property in a core market than a Class B property in a secondary market or a collection of Class C garden-style properties in a tertiary market.

Let’s take another approach to this by comparing similar expected rates of return instead of investment opportunities with different expected rates of returns.

Assuming we have two investments:

• Investment A = 8% return

• Investment B = 11% return

Investment A is a value-add investment from a trustworthy sponsor in a core market, and B is a similarly sized value-add investment from a less experienced sponsor in a secondary market. In this situation, an investor likely chooses A because though it has a lower return than the other, it's from a reputable and trustworthy sponsor.

From the above example, let's say that the volatility or total risk of investment for B is 8%. This means there is a risk of 8% based on the experience of the sponsor. Let's say A is at 4%. This means it has a lesser risk because the sponsor is experienced. We can calculate the Sharpe ratio as shown in the table below, assuming the risk-free rate of return is 3%.

Portfolio Type          A B

Expected Returns  8% - 11%

Risk-free rate  3%  - 3%

Volatility   4%  - 8%

Sharpe ratio       (8-3)/4 = 1.25%  (11-3)/8 = 1%

This shows that investment A is favorable compared to investment B using the Sharpe ratio.

Flaws With The Sharpe Ratio 

There are some limitations with the Sharpe ratio for investment due to certain assumptions. Some of the limitations are:

• The calculation of the Sharpe ratio is centered around the assumption that there's a distributed rate of return. This is not the case in the real market because the market might suffer from surprising spikes and drops.

• There's also the assumption that price movement in any direction is equally risky when using the standard deviation.

• The Sharpe ratio focuses on the volatility of a portfolio but not on the direction.

• The Sharpe ratio is also backward-looking since it makes use of historical returns and volatility, thereby assuming that the future performance of an investment will be similar to the past.

Conclusion

We have seen what the Sharpe ratio is and how it can be applied to multifamily real estate investing. Although we saw some limitations to the use of the Sharpe ratio in investment, it's still a comprehensive tool for measuring risk if used properly and alongside other instruments like the downside risk as used in the Sortino ratio. While it is good to measure the risk of any investment, due diligence is essential, especially in multifamily real estate investing. Rather than basing your investments blindly on expected rates of return, you should dig deeper to understand the risks. Take a closer look at some indicators, such as the age of the property (newer properties tend to be less risky), the market (from our examples, you can deduce that core markets are safer investments) and the quality of the sponsor.


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