How do you measure risk when investing?

Question

A common mistake I see for new investors is that they focus on finding the highest projected IRR. Experienced funds are offering 10-15% IRR yet newer syndicators are offering a 20-30% IRR.

So how does a newer syndicator finding/executing deals with drastically higher IRRs?

There are three simple answers:
1. They struck gold and found the deal that nobody else could.
2. They are taking on substantially more risk.
3. They are making lofty assumptions.

How do you measure the risk-adjusted returns of a syndication or investment?

Chris Levarek · Answer

@Jim Kittridge Good points. It is the responsibility of the investor to do some due diligence on the syndicator and also the market or deal. I mean that is the fun of it all if investing passively as well. Get one's hands in the clay and learn a bit. At least that's what I try and communicate.

If anyone is watching the market, they should be able to see that eviction moratoriums and unemployment affect delinquencies or economic vacancy in C class assets. So attempting to hit 20% IRR on such deals at present, is most likely hot air. Exit values will be affected by present incomes, so assets will be held longer affecting these IRRs. Will an investor know this right away, maybe not, but they can ask to see the projected vacancy numbers and if they seem too good, well...

Educate first, then invest. "The Hands-Off Investor" by Brian Burke is a good start.

Now is not a time to be overly optimistic or even greedy, 10% is a great return. 12% is even better, especially at present. Just my two cents though.

Bryan Hancock · Answer

Risk is often in the eye of the beholder, but from what you wrote above items 2 and 3 are highly more likely to be why a sponsor is offering higher proposed returns.  Those types of returns are a signal that the sponsor has to offer them to attract capital, which wouldn't be the case if they were more seasoned.

There are ground-up development projects that offer really high returns commensurate with risk, but I find that sponsors often fail to account for their time in these projects or if they do so they don't do a great job of doing it.  The returns are often far less impressive when you account for your time.  If the capital is working that hard it's one thing, but it is generally the sponsor working really hard and conflating their labor with a "return on investment."

There ain't no such thing as a free lunch.

Jim K. · Answer

@Bryan Hancock I couldn’t agree more

Jerel Ehlert · Answer

Risk is the probability that the return to you will be something other than what you bargained for.

Rates of return are compensation to you (the investor) for taking on the risk.  (At least part of the rate is, the other part being what the market pays comes into play also.)

The "eye of the beholder" (sorry) comes into play by your ability to recognize risk, accurately assess the impact to your return, and counter or ameliorate the risk.

Henry Clark · Answer

@Jim Kittridge

@Steve S.

Jim, feeding off your basic question below:How do you measure the risk-adjusted returns of a syndication or investment?All items in the above posts are noted.

Keeping it simple.

Factor 1 Return:  IRR% 15%  versus 30%;  30% is always better.

Factor 2 Risk:  Unfortunately there is not a similar Bond Rating system or service, showing AAA rating versus cc for REI.  Thus it is imperative on the IRR 15% offering to reflect their Risk Aversion (value) versus the 30% to create their Value comparison.  Otherwise the 30% will always win.  Most investors will always pick the higher return, especially given a better sales pitch.  Look at one of the forum posts, where the investors are negative on the syndicator.  If you look that syndicator up and see the BBB comments, one investor notes they researched their MFH property after issues came up and the properties around, I forget specifics were in the $80 to $120k range, but the house they bought cost them in the $220k range from the Syndicator.  Another investor notes they paid for upgrades, and when things went south, they noted the upgrades were not performed. Versus getting pictures as they were sending money in to the syndicator.

Also feeding off of Steve S response above.  Not all products are the same.  Steve S mentions a mix of returns from rent and also sale proceeds 5 to 7 years later.  Looking at your company background looks like your average investment turnover is 8 months.  Thus not apples to apples.  But as Steve S mentions, the quicker you get your money back the lower the risk, thus your deal from that standpoint is less riskier.

To me the Value creation for the 15% return investment is the following:

a.  We provide comp rates for similar properties in the area.  On a before and after retro basis.

b.  All upgrades are photo documented/communicated before/after for your review.

c.  Our investment holding periods average 8 months versus a 5 year payout.  Basically a Fix/Flip, versus a BRRR.  Greater liquidity in the "Same" market time period.

Please expand if I misinterpreted the direction of your question.

We do Self Storage, and it can be hard to differentiate value between our competitors and us; since they are both just metal buildings.  We have the same issue as your are noting, Value recognition.

Francis Louis Vogel Jr · Answer

Great read. Thanks

Eric Lefteroff · Answer

You are correct to say that there are 3 possible explanations but I would add that there isn't just 3.  Another explanation is that the way a deal is structured can heavily play into the IRR.  For example, 1) the degree of the managers fee can vary and has an impact on the IRR (the smaller the fee the higher the IRR, all else being equal); 2) the profit share percentage of the syndication manager is not equal across all deals; 3) investor prefs can boost their IRR; etc.

Typically, a newer more inexperience manager will not command a high management fee nor a high profit split percentage.  They will often have to offer a higher pref as well.  All these things can boost investor IRR as well.

How do you measure risk when investing?

Most Popular Reply