The holy grail of investing is great returns with no risk. 

The problem? That investment doesn’t exist. 

All investments have risk. 

Individual stocks, index-tracking ETFs, bonds, real estate, savings, cash in the mattress, etc., all have some risk. 

On one end of the spectrum, if you park money in an FDIC-insured bank savings account, you face capital risk over the FDIC coverage ($250K) and inflation risk (i.e., your money will have less spending power in the future). Return-wise, you have the potential for low single-digit gains – typically at or below the rate of inflation. 

On the other extreme, if you buy a highly volatile meme stock on margin, you risk a potential 50%-plus loss of your investment with a potential for very large gains. Essentially, though, you’re gambling. 

I think we all want something in the middle: a reasonably good return with an acceptable level of risk and limited volatility. 

But how do you measure an acceptable level of risk for a given level of return? And, how does that factor into portfolio construction?

I’m not a quant. I’m a business owner, individual investor, and commercial real estate investor/ operator. So I look at this from the perspective that any useful risk analysis model should be proven and work well but approachable enough that I can return to it and reuse it without mountains of analysis. 

Additionally, if you’re not familiar with how 37th Parallel was founded, we didn’t grow up in multifamily investing. 

We selected it because it had the best mix of several key factors: evergreen, tangible asset, food & shelter business, lack of disintermediation risk, proven long-term returns, etc. 

We also selected this asset class because it was essentially non-correlated to the stock and bond markets, while providing attractive risk-adjusted returns with current income and tax advantages… something very few investments can do. 

To provide more detail around the multifamily business case we need to review four investment metrics:

• Standard Deviation: essentially volatility
• Sharpe Ratio: the most common measure of risk-adjusted return
• Sortino Ratio: a better measure of risk-adjusted return, and
• Correlation: specifically the linear relationship between private commercial real estate and stocks. 

Once you understand how each of these investment metrics compare, you’ll understand why private multifamily is an obvious portfolio component. 

Let’s cover each in turn. 

Standard Deviation

Standard deviation is essentially volatility. In the context of investments, standard deviation is a statistical measure that quantifies the amount of variation or dispersion in a set of investment returns. 

It measures how much individual returns deviate from the average (mean) return. If the returns are close to the mean, the standard deviation will be low, indicating more stable performance. Conversely, if returns are spread over a wide range, the standard deviation will be high, indicating greater risk.

As you can see in the chart below, US commercial real estate is materially less volatile than Equities and REITs, and historically provided better returns than bonds and T-Bills. 

Some key observations in the chart below: 

• U.S. Equities and U.S. commercial real estate had similar returns in the 24-year period from 2000 to 2023. 
• Equities were more than twice as volatile. Note, part of this is because private real estate is not subject to the inflows and outflows of the market, which increases volatility. Another component, however, is that U.S. commercial real estate returns, as tracked by NFI-ODCE include net cash flows from operations and have little to no leverage. The cash flows smooth returns, and little to no leverage reduces volatility.
• U.S. REITs experience higher returns but at the cost of more than 3X the volatility of private real estate. 
• If you incorporate conservative leverage (50% LTV) to the U.S. private real estate return numbers, the annual average returns meet or exceed the returns from REITs, still with lower volatility.

The Sharpe Ratio

One of the most popular metrics for measuring risk-adjusted return is the Sharpe Ratio, introduced by Nobel laureate William F. Sharpe in 1966. The Sharpe Ratio is calculated by subtracting the risk-free rate from the portfolio’s return and then dividing the result by the standard deviation of the portfolio’s excess return.

The formula looks like this:

One of the main reasons we like apartments over other types of commercial real estate is its relative outperformance on a risk-adjusted basis. As you can see in the chart below, apartments had a higher average (mean) return, and a lower standard deviation (volatility), resulting in the best Sharpe Ratio among its commercial real estate peers. This trend has held up for any time period of 5 to 10 years or longer for multifamily going back decades. 

While the Sharpe Ratio is widely used, it has a specific limitation. It treats all volatility as negative. In other words, it penalizes upside volatility (when the investment performs better than expected) just as much as downside volatility (when the investment performs worse than expected). For many investors, this doesn’t make sense, because higher-than-expected returns shouldn’t be negatively viewed.

This is where the Sortino Ratio comes into play.

The Sortino Ratio

The Sortino Ratio, named after Dr. Frank A. Sortino, addresses the limitation associated with the Sharpe Ratio. It focuses solely on downside risk, which is more relevant for most investors.

The Sortino Ratio is calculated as follows:

By only considering downside deviation, the Sortino Ratio provides a clearer picture of the risk associated with an investment. It doesn’t penalize an investment for exceeding the expected return, which we believe makes it a more useful measure of risk-adjusted performance.

Furthermore, the Sortino Ratio does not assume that returns are normally distributed. This makes it more applicable to a broader range of investments, especially those with skewed return distributions or fat tails. For passive investors, this means a more accurate assessment of the risk and return profile of their investments.

Ultimately, the Sortino Ratio offers a more investor-relevant approach to measuring risk-adjusted returns by emphasizing what really matters – how much downside risk you are taking. This makes it a valuable tool for evaluating individual investments and overall portfolio performance.

For comparison, the Sortino Ratio of private commercial real estate is almost twice the Sortino ratio of the S&P from 2000 – 2023

This is obvious when you consider the long-term performance of real estate vs. stocks and bonds.

This brings us to our final metric.

Correlation

Correlation in the context of investments is a statistical measure that describes the degree to which two assets move in relation to each other. It is expressed as a correlation coefficient, which ranges from -1 to +1:

• +1 (Perfect Positive Correlation): If two assets have a correlation of +1, they move in the same direction. If one asset’s price increases, the other’s price also increases by the same percentage.
• 0 (No Correlation): A correlation of 0 means there is no predictable relationship between the movements of the two assets. The price movements of one asset do not predict or affect the price movements of the other.
• -1 (Perfect Negative Correlation): If two assets have a correlation of -1, they move in opposite directions. If one asset’s price increases, the other’s price decreases by the same percentage.

All other investment attributes being equal, you want to hold a basket of assets that have a mix of low correlation or inverse correlation to each other. By doing so, it’s proven that you can lower the overall volatility of your portfolio – thereby increasing your risk-adjusted returns. 

See the correlation table below with regard to Stocks, Bonds, and Real Estate. As you can see, bonds can be strongly correlated or inversely correlated to stocks. On the other hand, private real estate is almost always non-correlated or inversely correlated to Stocks, which is very useful.

When you keep in mind the overall investment characteristics of the private multifamily asset class: 

• Evergreen 
• Food & Shelter (Basic Need)
• Tangible Asset (the opposite of bitcoin)
• Proven long-term positive return history
• Highly tax-advantaged

And when you understand the risk-adjusted returns and lack of correlation to public markets, it’s obvious why the largest and smartest investors in the world – pension funds, endowments, sovereign wealth funds, and insurance companies – use private multifamily real estate in their portfolios.