Understanding Risk-Adjusted Returns in Single-Family Rentals and Alternative Investments

In the world of investing, understanding the relationship between risk and return is crucial. While higher returns often come with higher risks, the key to successful investing lies in maximizing returns while minimizing risk. This is where the concept of "risk-adjusted returns" comes into play. In this article, we'll explore this concept, how to calculate it for single-family rentals, and the idea of investing in alternatives outside of the publicly-traded markets.

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What Are Risk-Adjusted Returns?

Risk-adjusted returns are a measure of the profits made from an investment, taking into account the risk involved. In other words, it's a measure of how much risk is associated with producing a certain level of return. This is important because while one investment might generate higher returns, it might also involve a higher level of risk. Therefore, when comparing investments, it's essential to consider both the returns and the risk involved.

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Calculating Risk-Adjusted Returns

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Source:  Business Insider 

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There are several ways to calculate risk-adjusted returns, but one of the most common methods is using the Sharpe Ratio. The Sharpe Ratio is a measure that helps investors understand the return of an investment compared to its risk. The formula for the Sharpe Ratio is:

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Sharpe Ratio = (Return of Investment - Risk-Free Rate) / Standard Deviation of the Investment's Returns

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The "Return of Investment" is the average return of the investment over a certain period. The "Risk-Free Rate" is the return of a risk-free investment, such as a U.S. Treasury bond. The "Standard Deviation of the Investment's Returns" is a measure of the investment's volatility.

A higher Sharpe Ratio indicates that the investment has higher risk-adjusted returns. In other words, for the same level of risk, an investment with a higher Sharpe Ratio provides higher returns.

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Risk-Adjusted Returns in Single-Family Rentals

When it comes to single-family rentals (SFRs), calculating risk-adjusted returns can be a bit more complex due to the various factors involved. These factors include rental income, property appreciation, expenses such as maintenance and property taxes, and the risk associated with property ownership.

However, historical data shows that SFRs can offer attractive risk-adjusted returns. According to data from Roofstock, a leading player in the SFR market, the average annual returns in the single-family rental market are on par with those of the stock market and surpass those of bonds, but with significantly less volatility^[1].

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To calculate the risk-adjusted returns for SFRs, you would need to consider the average annual return of your rental income (after expenses), the appreciation of the property, and the standard deviation of these returns. You would also need to consider the risk-free rate, which could be the return of a long-term U.S. Treasury bond.

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For example (**), let’s say an investor is considering adding a single-family rental to a portfolio that has returned 15% over the last year. The current risk-free rate is 3%, and the annualized standard deviation of the portfolio’s monthly returns was 10%, which gives it a one-year Sharpe Ratio of (15-3)/10 i.e. 1.2 

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Sharpe ratios exceeding 1 are typically deemed favorable, indicating returns that surpass volatility. However, the evaluation of a Sharpe ratio is often relative, involving comparisons with similar portfolios or funds within the same market sector. Therefore, a portfolio with a Sharpe ratio of 1 may be viewed as subpar if the majority of its competitors have ratios exceeding 1.2, for instance. 

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Note - As of June 30, 2023, the S&P 500 Portfolio Sharpe ratio is 0.88 ^[2]

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Investing in Alternatives Outside of Publicly-Traded Markets

Investing in alternatives refers to investments in asset classes other than stocks, bonds, and cash. This could include real estate, commodities, private equity, hedge funds, and more. 

These types of investments are often used to diversify an investment portfolio and can offer higher returns, albeit often with higher risk.

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Investing in alternatives outside of the publicly-traded markets, such as single-family rentals, can offer several advantages:

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1. Diversification: Alternative investments can provide diversification benefits to your investment portfolio, helping to reduce risk.

2. Potential for Higher Returns: Some alternative investments, such as real estate and private equity, have the potential to offer higher returns than traditional investments.

3. Lower Volatility: Some alternative investments, such as real estate, tend to have lower volatility than publicly-traded investments, leading to more stable returns.

4. Inflation Hedge: Certain alternative investments, such as real estate and commodities, can act as a hedge against inflation, helping to protect your purchasing power.

However, it's important to note that alternative investments also come with their own set of risks, including liquidity risk, market risk, and specific risks related to the particular investment. Therefore, it's crucial to thoroughly research any alternative investment and consider seeking advice from a financial advisor.

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Conclusion

Understanding risk-adjusted returns is crucial for making informed investment decisions. While single-family rentals and other alternative investments can offer attractive risk-adjusted returns, it's important to consider the risks involved and ensure that any investment aligns with your financial goals and risk tolerance.

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Investing in single-family rentals and other alternatives outside of the publicly-traded markets can offer diversification benefits and the potential for higher returns. However, these investments also come with their own set of risks, and it's crucial to thoroughly research and understand these risks before investing.

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** Please note this example is a fictional scenario presented for the sole purpose of showing how to calculate a Sharpe Ratio for a single-family rental property. The numbers in this example are purely hypothetical.

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Please note that the information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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[1]: [Roofstock](https://learn.roofstock.com/blog/single-family-rentals-offer-strong-investment-alternative-to-stocks-and-bonds-with-far-less-volatility)

[2]: PortfoliosLab. "S&P 500 Portfolio.

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