One of my favorite parts about this business is introducing investors to the world of syndications and private placements.
For most of their investing life, they’ve been told to expect 7-8% annual returns from the stock market. I love seeing the spark in their eye when they learn that baseline returns for many syndications is nearly double that. For a moment, they’re filled with wonder as a whole new arena of possibilities opens up.
But occasionally, this wonder morphs into something resembling greed.
More and more deals come across their desk. They see pitch decks with projected annual returns into the 20-30% range. Before long, an apartment deal with a 15% IRR looks boring.
I recently had an investor tell me: “I’m not interested in anything below a 20% IRR. My inbox is full of deals. I can get 20% any time I want.”
How Much Risk?
There is no shortage of syndications to invest in. And even today, with a slower macroeconomic environment, I still personally see lots of deals with 20%+ projected annual returns.
So there’s no doubt that you could invest in deals projecting 20%+ “any time you want.” But investors with this mentality aren’t asking a crucial question:
How much additional risk am I taking on to achieve this return?
Risk-Adjusted Returns
The proper way to look at any investment return is through a risk-adjusted lens.
I’m going to skip all the math formulas (look up Sharpe Ratio if you want to nerd out), and instead illustrate this with an extreme example. Imagine you’re looking at two deals, both projecting a 15% annual return (play along with me here):
A portfolio of US Treasury Bonds
A ground-up office building construction project
An investor looking only at returns sees these as identical. But they clearly aren’t – the T-Bond portfolio has significantly less risk than the office building.
Said another way: you’re much more likely to actually achieve the 15% return from the T-Bond portfolio than the office project, where there’s a much greater chance of achieving no return at all and losing all your investment.
These distinctions are clear in an extreme example. But now imagine a more real-world scenario:
A value-add apartment building, projecting 15% IRR
A ground-up office building construction project, projecting 25% IRR
Is the office project more risky than the apartment building? Probably. But there’s not enough information to know for sure. You would need to perform detailed deal due diligence (how’s that for alliteration?) to confirm.
If your due diligence reveals that there’s a significantly greater chance of losing all your investment on the office building as compared to the apartments, then is the additional 10% annual return worth the risk?
There’s no “right” answer here, as investment objectives and risk tolerance are different for everyone. But the point is to ask the question and make the determination for yourself. Avoid falling into the trap of evaluating syndications based solely on their projected returns.
A couple months ago, I wrote about the trade-offs in investing, one of which is risk. For any investment you make, you must have a clear understanding of how much risk you’re actually taking on, and whether the projected returns are high enough to compensate for it.