To 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.
From 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.
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.
There are several ways in measuring risk of an investment. In real estate, individual markets present their own risks that influence the ability to generate revenue with limited variation in performance. The coefficient of variation is just one tool to measure and evaluate this risk.