Welcome to Ivan’s breakdown of what the “risk-adjusted return” is. In the following body of text, you will see a transcription of the above video.
What is the risk-adjusted return?
Google & Investopedia says it’s the measure of profit that your investment has made relative to the amount of risk the investment represented throughout a period. If two or more investments delivered the exact same return over the same period of time, the one with the lower risk would have a better risk-adjusted return.
Why do I think multifamily offers some of the best risk-adjusted returns in the market?
- Well, number one, the security or the investment is backed by real assets. It’s not a piece of paper; it’s a piece of real estate. You can’t steal it; you can’t move it. It is real.
- Number two, apartments offer superior leverage. Lots of newbies screwed this up in the last couple of years, and it’s hurting them. However, the experienced sponsors use leverage wisely and put hedges in place to offset unforeseen circumstances in the market.
- Number three, and this is always true, somebody somewhere is screwing it up, which creates opportunities for strong sponsor teams to turn around those deals and force that appreciation. That’s another video. And what’s always true is rental housing is always in demand. There’s a certain percentage of the population that will always rent. It’s very tough to replace and nearly impossible to disrupt.
How calculate the risk-adjusted return on capital (RAROC), follow these steps:
- Determine Net Income: Calculate the net income from the investment after expenses. This is the profit that the investment generates.
- Calculate Expected Loss: Estimate the expected loss from the investment. This involves assessing potential losses due to credit risk, market risk, operational risk, etc.
- Identify Economic Capital: Economic capital is the amount of capital required to cover potential unexpected losses. This is determined based on the risk profile of the investment.
- Calculate RAROC: Use the formula:
RAROC=Net Income – Expected Loss ÷ Economic Capital
This formula provides a measure of returns adjusted for the risks taken. A higher RAROC indicates a more efficient use of capital in terms of risk and return.
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