Are returns competitive

Okay, so I’m looking at different investment options, specifically in the real estate market. I’ve been reading about commercial real estate and specifically distressed commercial real estate opportunities. I’m not talking about flipping houses, but more like acquiring underperforming office buildings or retail spaces, renovating them, and then leasing them out or selling them.

My big question is: How do the potential returns on distressed commercial real estate compare to other investment options of similar risk? I know things like treasury bonds are "safer" but also have lower returns. I’m more interested in comparing it to something like:

• Private Equity funds investing in similar sectors
• REITs (Real Estate Investment Trusts), especially ones focused on repositioning assets
• Direct investment in other alternative asset classes, like venture capital (though maybe that’s too risky for comparison)

I’m really struggling to find reliable data on average returns for distressed commercial real estate, especially considering the risks involved. Things like interest rate hikes, economic downturns, and even just unforeseen renovation costs can drastically affect the profitability. So when people talk about competitive returns, what benchmark should I be looking at? What kind of returns would be considered competitive for the level of risk involved with turning around distressed properties? Are there specific metrics, like IRR (Internal Rate of Return) or cash-on-cash return, that I should be focusing on to evaluate potential deals? Also, what is a realistic timeline for seeing those returns?

Answer

To determine if returns are competitive, one needs to consider several factors and compare them against relevant benchmarks. Here’s a breakdown of the elements involved in assessing the competitiveness of returns:

1. Definition of "Returns":

• Absolute Returns: This refers to the actual gain or loss on an investment, expressed as a percentage of the initial investment. For example, a 10% absolute return means the investment grew by 10%.
• Risk-Adjusted Returns: This measure considers the level of risk taken to achieve those returns. Higher returns are generally expected for investments with higher risk. Common metrics include the Sharpe Ratio (return per unit of total risk), Treynor Ratio (return per unit of systematic risk), and Jensen’s Alpha (excess return above what’s expected for the level of risk).
• Total Return: This includes all income and capital appreciation from an investment. For example, with a stock, it would include dividends plus any increase in the stock price. For a bond, it would include coupon payments plus any change in the bond’s price.
• Net Return: This is the return after all fees, expenses, and taxes have been deducted. This is the return the investor actually receives.

2. Benchmarking:

• Market Indices: Common benchmarks include the S&P 500 (for large-cap US stocks), the Russell 2000 (for small-cap US stocks), the MSCI EAFE (for international developed market stocks), and the Bloomberg Barclays US Aggregate Bond Index (for US investment-grade bonds).
• Peer Groups: Compare the returns of a fund or investment strategy to other funds or strategies with a similar investment objective and risk profile. Services like Morningstar or Lipper provide peer group data.
• Historical Performance: Comparing current returns to the historical performance of the same investment or strategy can provide insights into whether recent performance is typical or an outlier.
• Target Return/Required Rate of Return: Investors often have a specific return target based on their financial goals and risk tolerance. Returns should be evaluated against this target.

3. Factors Influencing Competitiveness:

• Investment Type: Returns vary significantly across asset classes. Stocks generally offer higher potential returns than bonds but also carry higher risk. Real estate, private equity, and hedge funds have their own risk/return profiles.
• Time Horizon: Returns should be evaluated over a relevant time period. Short-term performance can be volatile and may not be indicative of long-term results. A longer-term perspective (e.g., 5-10 years or more) is often more meaningful.
• Risk Level: Higher-risk investments should generally be expected to deliver higher returns over the long term to compensate investors for the increased risk.
• Economic Environment: Market conditions, interest rates, inflation, and economic growth all influence investment returns.
• Management Skill: In the case of actively managed funds, the skill of the portfolio manager can have a significant impact on returns.
• Fees and Expenses: Higher fees reduce net returns. Investors should consider the impact of fees when evaluating competitiveness.
• Taxes: Taxes can significantly reduce investment returns. Investors should consider the tax implications of different investments.

4. Process for Evaluating Competitiveness:

1. Identify the Investment: Clearly define the investment being evaluated (e.g., a specific mutual fund, a stock portfolio, a real estate investment).
2. Determine the Relevant Benchmark(s): Select appropriate market indices or peer groups for comparison.
3. Gather Performance Data: Obtain historical return data for the investment and the benchmark(s) over a meaningful time period.
4. Calculate Relevant Metrics: Calculate absolute returns, risk-adjusted returns (Sharpe Ratio, etc.), and net returns.
5. Compare Performance: Compare the investment’s returns to the benchmark(s) and to peer group averages.
6. Consider Risk: Evaluate the level of risk taken to achieve the returns. Were the returns commensurate with the risk?
7. Analyze Fees and Expenses: Assess the impact of fees and expenses on net returns.
8. Consider the Economic Environment: Take into account the market conditions and economic factors that may have influenced returns.
9. Draw Conclusions: Based on the analysis, determine whether the returns are competitive relative to the benchmarks, peer group, risk level, and fees.

Example:

Let’s say you’re evaluating the performance of a US large-cap equity mutual fund over the past 5 years.

• Benchmark: S&P 500 Index
• Data: Gather the fund’s annual returns and the S&P 500’s annual returns for the past 5 years.
• Calculations: Calculate the fund’s average annual return, Sharpe Ratio, and expense ratio.
• Comparison: Compare the fund’s average annual return and Sharpe Ratio to the S&P 500’s average annual return and Sharpe Ratio. Compare the fund’s expense ratio to the average expense ratio of similar large-cap equity funds.
• Conclusion: If the fund’s average annual return and Sharpe Ratio are higher than the S&P 500’s, and its expense ratio is in line with or lower than its peers, the returns could be considered competitive. However, you’d also want to examine the fund’s risk profile to ensure it aligns with your investment objectives.

In summary, determining if returns are competitive requires a thorough analysis of the investment’s performance relative to appropriate benchmarks, considering risk, fees, and the economic environment. It is not a simple yes or no answer, but rather a nuanced assessment based on multiple factors.