Knowing what to ask is the trick to getting the right answer.
In The Hitchhiker’s Guide to the Galaxy, a supercomputer called Deep Thought is asked to answer the Ultimate Question of Life, The Universe and Everything. After 7.5 million years, Deep Thought reports back that the answer is 42. When questioned, Deep Thought points out that the answer seems meaningless only because it was not clear what the question was.
Calculating real estate risk can produce a similarly unclear answer for the people who asked for it and usually requires further clarification.
To provide a clear answer, a fund risk measure should quantify the likelihood of delivering an investment objective and of falling below a minimum level of return.
To illustrate, if the expected unleveraged return of a fund is 7% and the standard deviation is calculated as 3.5%, then the probability of achieving a 7% target rate of return is 50%, with a 16% chance of falling below a fund return of 3.5%.
Comparisons of these likelihoods can then be made to those for different portfolio structures, when adding leverage or for different funds. In our illustration, for example, adding leverage of 30% at an interest rate of 235 basis points increases the expected return to 9%, which boosts the likelihood of achieving the 7% target rate of return to 65% and reduces the chance of falling below 3.5% to 14%.
Chart 1: fund risk
Having a clear answer is one thing, ensuring confidence in the answer is another. The first way to engender confidence is to be transparent as to the calculations.
Future expected returns in any sector depend upon assumptions for growth, capital costs, vacancies, irrecoverable costs and price movements.
Future returns = Initial yield + growth – capital costs – vacancies – irrecoverable costs + yield change*
*Depreciation is captured in the growth, capital costs and yield change assumptions.