a Berkshire Hathaway and Leucadia National company

APARTMENT ADVISORY SEPTEMBER 2017

DETERMINING RISK VS. REWARD IN TOP APARTMENT MARKETSTo manage risk across an investment portfolio, measuring the range of probable outcomes is key in identifying opportunity and developing a sound strategy in where and how to deploy capital. The coefficient of variation is one such measurement.

The coefficient of variation ratio enables investors to make decisions based on the amount of risk per unit of return. The ratio, calculated as the standard deviation of returns divided by average returns, is useful when comparing investments with varying degrees of standard deviations and returns. The lower ratio, the lower amount of risk per unit of return.

Depending on investors’ appetite for risk within the multifamily industry, risk-averse investors will identify markets with limited volatility relative to steady growth. Investors with a larger appetite for risk will accept markets with greater levels of volatility in performance.

To determine risk by market, we take the annual average revenue growth and the standard deviation over the last 10 years. For purposes of this piece, we examined 20 developed, mature markets that generally attract greater capital and are viewed as centers for economic growth and commerce.

PHOENIX HAS THE GREATEST RISK, BOSTON RECORDS THE LOWESTFrom the table above, Phoenix, Atlanta, and Los Angeles present the greatest risk per unit of return over the last 10 years. Meanwhile, Boston, Denver / Boulder and San Diego feature the lowest ratios, therefore lowest risk.

There are generally weaknesses and concerns for every market. Although the riskier markets have faced substantial headwinds: Phoenix’s employment base was hit hard during recession and only recently recovered; Atlanta’s for-sale housing market was plagued by foreclosures and negative equity; and Los Angeles continues to struggle with structural issues around affordability and availability of housing, broadly.

The stronger markets may have fewer concerns, but they are there. For example, San Diego has a high cost of living, even though its business environment is very supportive. Boston has strong demographics, but the cost of living and conducting business is high, and the market also has exposure to the cyclical financial sector. Dallas ha a diversified, business-friendly economy, but its apartment supply has been elevated for quite some time and has been starting to moderate in the past year.

DIFFERENCES FOUND ACROSS ASSET CLASSES

To take our examination of risk a step further, we took the coefficient of variation ratio for the same metros, but separated performance across asset classes. The most noticeable trend is the wide range of ratios in Class C properties. Detroit, Atlanta and Phoenix posted negative revenue growth during the 10-year period, which distorts the ratio value. Class A properties present the lowest risk per unit of return given a tighter range of ratios, from 1.18 in Chicago to 0.56 in Denver / Boulder.

Coefficient of Variation

Source: RealPage

Coefficient of Variation by Asset Class

Source: RealPage

© 2017 Berkadia Proprietary Holding LLCBerkadia® is a trademark of Berkadia Proprietary Holding LLC. Axiometrics® is a trademark of Axiometrics Inc. Commercial mortgage loan origination and servicing businesses are conducted exclusively by Berkadia Commercial Mortgage LLC and Berkadia Commercial Mortgage Inc. This newsletter is not intended to solicit commercial mortgage loan brokerage business in Nevada. Investment sales and real estate brokerage businesses are conducted exclusively by Berkadia Real Estate Advisors LLC and Berkadia Real Estate Advisors Inc. For state licensing details for the above entities, visit: www.berkadia.com/legal/licensing.aspx

a Berkshire Hathaway and Leucadia National company

SEPTEMBER 2017APARTMENT ADVISORY

SHARPE RATIO MEASURES RISK PREMIUM PER DEVIATION UNITAnother tool to assess risk of a market is the Sharpe Ratio, which measures the risk premium per unit of deviation. It is dervived by subtracting the risk-free return from the average return and dividing the difference by the standard deviation. The higher the Sharpe Ration, the higher premium in returns you see given the risk factors.

Using NCREIF data, the Sharpe Ratio also shows Phoenix as the metro with the lowest premium over the past 10 years. Phoenix’s ratio of 28.5% is by far the lowest among the 17 markets ranked, followed by Philadelphia and Washington, D.C. Los Angeles, which was No. 3 for coefficent of variation, had the fourth lowest Sharpe Ratio. (Not enough data was available for Detroit, Oakland, and Orange County to determine a Sharpe Ratio.)

Meanwhile, the markets with the highest Sharpe Ratios differ from those at the top of the coefficient of variation chart. San Diego was the only metro to make the top three in both measurements, with Dallas and Minneapolis-St. Paul also among the highest-premium markets.

STANDARD DEVIATION, RETURNS IN BALANCE IN STRONGER METROSThe chart at the top right of this page compares the standard deviation in each market to their 10-year total mean returns. Unsurprsingly, the two measurements were quite similar in the metros with the four highest Sharpe Ratios -- anywhere from absolutely equal (Denver / Boulder) to 80 basis points (Minneapolis-St. Paul).

At the other end of the Sharpe spectrum, the markets with the lowest ratios had major differences between standard deviation and returns. With a couple of exceptions (Denver / Boulder), the standard deviations tended to be higher than the top-ranked metros, while in all cases the returns were much lower. Phoenix recorded the biggest difference (890 basis points), followed by Los Angeles, (540 basis points) and Philadelphia (530 basis points).

Risk is a given when it comes to real estate investing, and using several methods of determining risk can go a long way toward making wise investment decisions. While the coefficient of variation and Sharpe ratio rank the metros somewhat differently, it’s relatively easy to identify the markets in which the risk / return is strong and those in which they are weak.

Of course, these are for full markets only. The submarkets within them will have plenty of differences among themselves and should be assessed.

© 2017 Berkadia Proprietary Holding LLCBerkadia® is a trademark of Berkadia Proprietary Holding LLC. Axiometrics® is a trademark of Axiometrics Inc. Commercial mortgage loan origination and servicing businesses are conducted exclusively by Berkadia Commercial Mortgage LLC and Berkadia Commercial Mortgage Inc. This newsletter is not intended to solicit commercial mortgage loan brokerage business in Nevada. Investment sales and real estate brokerage businesses are conducted exclusively by Berkadia Real Estate Advisors LLC and Berkadia Real Estate Advisors Inc. For state licensing details for the above entities, visit: www.berkadia.com/legal/licensing.aspx