I'm wondering which REI metric is best to use when comparing a Real Estate deal to the return on the Stock Market. In addition, how do I know if I'm receiving an appropriate risk premium for the extra risk I'm taking on in a Real Estate Investment when comparing to just investing in stocks?
I want to analyze a deal and know whether it's worth it to pursue the deal opposed to just investing in the stock market to earn a 7% annual return. Would Cap Rate be the appropriate metric? Is there a way to risk adjust the metric so that I can compare apples to apples with stock market returns?
I realize the Cash-on-cash return will tell you how much you earn on your cash investment, however, this factors in leverage and doesn't seem risk adjusted to me (i.e. I'm taking on more risk by using leverage and would assume the returns to be higher).
Bottom line, if I'm going to invest in Real Estate, how am I sure I'm adequately compensated for the risk premium I'm taking on over just investing in stocks?
Cap rate isnt even a measure of return, so no go on that.
IRR, Internal Rate of Return is your best bet....but it is by no means a perfect metric.
Real estate investment is pretty broad - there is buy and hold, flipping, development, commercial, etc each with their own risk and return characteristics. IMO, you would have to pick more specific segment of real estate investment before making a productive risk vs return comparison to the stock market.
It's important to understand the return structure in real estate before selecting any of the performance metrics thrown around here and use them to compare to the stock market. For example, at least three types of return can be generated from a buy and hold investment: -cashflow, -loan paydown, - appreciation. (Some would add tax benefit as a return but I digress). A cash on cash metric only takes into account cashflow and loan paydown so it doesn't reflect the whole return of the investment. As pointed out before, cap rate is not even a performance metric so forget that. However, IRR does take into account all three types of return so it is a good candidate to use as a comparison metric against the stock market.
As far as risk premium and whether or not you are adequately compensated for the additional risks associated with real estate, well I think the onus is on you. You, the investor, make the assessment whether or not you're adequately compensated for taking on the additional risks. To me this means you, the investor, need to study and educate yourself on the risks inherent in real estate, just as you have educated yourself on the risks associated with stock investments. This is the same process an investor goes through when deciding to invest in Netflix (i.e. growth stock) as opposed to Coke (i.e. income stock)... that is, by studying them and make the assessment of which is more acceptable.