The Returns Fallacy: Contemplating Volatility in Real Estate Targeted Returns

The assumption that the path to high realized portfolio returns is simply the sum of a series of high individual targeted returns is a recipe for disaster. In this article we describe the Returns Fallacy and describe techniques investors can use to improve their realized investment returns.

There is a lot more to understanding investment returns in a commercial real estate deal than a quick glance at summary metrics and it starts with targeted returns. The assumption that the path to the high realized portfolio returns is simply the sum of a series of high individual targeted returns is a recipe for disaster. Despite this, it is tempting for investors to take information at face value, because challenging assumptions requires some context. This is why it is common for less sophisticated investors to fall prey to what I refer to as the “Returns Fallacy”.

The Returns Fallacy begins with assuming that all deals are created equal and, as a result, simply selecting a portfolio of investments that target the highest returns. A simplistic analysis suggests that a targeted Internal Rate of Return (“IRR”) of 20% is better than a 15% targeted IRR, right? Wrong. When investors select investments based solely on the criteria of a targeted IRRs, they ignore the volatility assumed in achieving those targeted returns. In this article, we will explore how risk intertwines with targeted IRRs with a focus on volatility of returns.

The four food groups for risk

I previously published an article that discusses the four main risk-profile categories in depth. For the purposes of this article, I will revisit only the highlights of each category, which represent a sliding scale for risk starting with core strategies as the safest play and gradually stepping out farther on that risk spectrum with opportunistic strategies viewed as the riskiest.

Core properties are relatively stable assets that are typically located in major metros, such as high-rise office towers or apartment buildings in New York City, Chicago or San Francisco. They are best-in-class properties in top locations with high occupancy levels and good credit tenants.

Core plus assets may share many of the same characteristics as core assets with one or more exceptions that create an added layer of risk. Some examples of those exceptions might include the age or condition of the asset, lower tenant credit or a less than stellar location.

Value add assets generally have a problem that needs fixing, such as leasing to improve significant vacancy, building renovation or bringing in new tenants to boost the quality of the rent roll. The purchaser is usually coming in with a specific business plan to improve an underutilized asset.

Opportunistic deals are often extreme turnaround situations. There are major problems to overcome, such as a large vacancy, structural issues or financial distress. Opportunistic strategies may involve acquiring distressed or foreclosed assets from banks or servicers.  Alternatively, opportunistic investors may also acquire senior loans of distressed assets at a discount from banks or servicers with a plan to either implement a workout with the existing borrower and sell the loan or take title to the asset via foreclosure on the borrower.

Core vs. Opportunistic Investment Example

Now that we have revisited the four categories of investment risk, let’s compare two different office investment examples:

  1. Core Office Deal

Asset Class

A – Trophy


Single – Credit


Primary Market – Central Business District (“CBD”)

Loan to Value


Current Occupancy


Stabilized Occupancy


Average Remaining Lease Term

15 years

Holding Period

7 years

Targeted Investor IRR



  1. Opportunistic Office Deal

Asset Class

B – Historic


Multi-tenant – no credit


Secondary Market – CBD

Loan to Value


Current Occupancy


Stabilized Occupancy


Average Remaining Lease Term

2.5 years

Holding Period

4 years

Targeted Investor IRR



When comparing these two investment choices, it’s easy to become seduced by the allure of a targeted 20% IRR and opt for the opportunistic office deal, but is it really better than the core deal? Perhaps, but to make that determination, it is critical to assess the key attributes of each deal and how they affect the likelihood of the asset achieving its targeted returns:

  1. Asset Class – Class A office is superior to Class B office all things equal. In general, it will lease faster and easier than Class B office, which is particularly true in a CBD location.

  2. Property Condition – The better the condition of the asset, the higher the probability that budgeted operating costs will equal actual operating costs and the lower the probability that unforeseen costs will occur.

  3. Tenant Profile – The stronger the tenant, the higher the probability that the tenant performs over the term of its lease. Once tenants reach a AAA credit rating level (such as Microsoft and Johnson & Johnson), their debt is actually considered safer than U.S. Treasury bills and bonds. If you combine tenant credit with term, you essentially have a very safe bond.

  4. Location – Primary markets are considered less risky than secondary markets due to their superior liquidity. International investors will always invest in primary U.S. markets but not always in secondary markets. Sustained international demand for primary markets creates a stronger asset value floor relative to secondary and, especially, tertiary markets.

  5. Loan to Value – The lower the debt amount, the lower the required debt service, which means the lower the probability of defaulting on a debt service requirement and losing the asset to the lender.

  6. Current Occupancy to Stabilized Occupancy – Average Remaining Lease Term – The longer the average remaining term, the lower the amount of lease roll or exposure to risk that current tenants vacate instead of renewing their leases. A longer average term creates greater certainty, which limits downside risk, but it also limits upside potential as it locks in lease rates, and thus income, for a longer period of time.

  7. Holding Period – Holding period cuts both ways from a risk perspective. The longer the holding period the more exposure to macroeconomic and real estate cycle risks. Alternatively, the shorter the holding period, the greater the concentration of risk that things need to right within a specific time frame to achieve the business plan. Generally speaking, the further you get into a current cycle, the stronger the argument becomes for longer holding periods since you hedge against the possibility of hitting your exit window during a downturn.

From the information provided above, we now know one critical piece of information:

Example #1 has a much higher probability of hitting its targeted IRR of 10% than Example #2 has of hitting its targeted IRR of 20% or, in other words, Example #1 has much less implied volatility in its targeted returns.


  1. A Class A trophy asset will have more predictable operating costs than a Class B historic asset. Any building, regardless of its type, becomes more unpredictable with age. A Class B historic asset may experience costly issues with systems such as elevators and HVAC’s that are less likely to occur with a newer building.

  2. In the first example, the Core deal doesn’t even need to maintain all of its current occupancy to achieve its stabilized goal. In the Opportunistic deal, the operator needs to increase occupancy from 60% to 95% to hit stabilization.

  3. Example #1 has a single credit tenant, while Example #2 relies on multiple non-credit tenants. The risk of a tenant defaulting on its lease is exponentially higher in Example #2.

  4. In addition, with 15 remaining years of average lease term, the Core deal, with its single credit tenant, will almost certainly still be 100% occupied at exit with 8 years of remaining term – enough to command a high exit valuation. The Opportunistic deal has a tremendous amount of uncertainty both in leasing up to a 95% stabilized occupancy as well as exposure of lease roll during the holding period.

  5. Example #1 is located in a Primary market, which is generally considered superior to a Secondary market for the reasons noted above.

  6. With a four-year holding period, Example #2 will rely upon a positive leasing environment to hit its occupancy goals and will likely fail to achieve stabilization if a downturn hits inside of the prescribed holding period.

A good way to think about the difference between Example #1 and Example #2 is to view them through a standard deviation to targeted returns graph:


In the graph above, the blue and grey bars represent the targeted IRRs for the Core Deal (9%)  and Opportunistic Deal (20%) respectively. The error bar for each deal represents a one standard deviation variance in each deal’s return – 5% for the Core deal and 30% for the Opportunistic deal. The standard deviation in the error bar is a visual representation of the implied volatility of each deal’s targeted returns.

Therefore, within a one standard deviation move from each deal’s targeted return (which statistically speaking captures 68.2% of probable outcomes) you get the following upside and downside scenarios:



Downside IRR

Upside IRR

Example #1



Example #2




In the upside scenario, the Opportunistic deal far out earns the Core deal by a margin of a 36% IRR. However, in the downside scenario, the Core deal still earns a positive return while you take a loss on the Opportunistic deal. What this essentially means is that the Core deal is safe – you can only realistically hope for a 14% IRR but you also have only an outlier chance of losing money. This is the type of deal where you can sleep safely knowing your investment is secure. If capital preservation is paramount, then Example #1 is your deal.

Conversely, the Opportunistic is highly risky – it has huge upside with a 50% IRR but you also lose money within a one standard deviation move to the downside if things don’t go according to plan. This type of investment is ideal for high-risk capital where you accept the possibility of a loss in exchange for the opportunity to achieve a substantial equity multiple.

So, given the disparity in risk, does this mean that Example #1 is a superior investment to Example #2? Not necessarily. Example #2 may, in fact, be superior to Example #1 in the final analysis. The point is that whether or not Example #1 is a better fit for your portfolio than Example #2 highly depends upon your investment objectives and your tolerance for risk.

Snapshot of risk-adjusted returns

As demonstrated above, risk goes hand-in-hand with the reward or projected return. No investor wants to take on the high risk of a value-add or opportunistic investment only to be compensated at a rate that is more on par with a lower risk core or core-plus deal. While every situation is unique, general guidelines exist to help determine whether the amount of risk for any given deal is commensurate with the targeted amount of return, otherwise known as a risk-adjusted return. Based on data from more than 80 deals offered on the CrowdStreet Marketplace since April of 2014, the following is a snapshot of targeted IRRs for different risk profiles. While by no means an absolute guide, the matrix does provide ranges of actual targeted IRRs with corresponding risk profiles that CrowdStreet determined to as generally commensurate with the amount of assumed risk at the time the offering was brought to market:


Basic portfolio strategy: Diversify risk

In a perfect world, an investor could simply pick the investment opportunities with the highest IRRs and lock in high returns. However, you now know that such a strategy would only serve to expose that investor to the Returns Fallacy. Diversification is the antidote to Returns Fallacy as it improves overall portfolio returns while also reducing risk – a concept known as moving closer to the efficient frontier. Portfolio diversification can be achieved in a variety of ways, such as investing across property types and geographic markets, as well as with different sponsors and business plans. It also is important to allocate capital across different risk profiles, particularly as we know that commercial real estate is cyclical. That diversification can be especially important in building a portfolio that can withstand a market downturn.

How an investor chooses to weight that diversification depends on an individual’s tolerance for risk. It is also important to note that some investors look to commercial real estate as a specific vehicle for taking higher risk to target higher returns and diversify risk through other asset classes such as fixed income. While there are no absolute right or wrong answers when it comes to real estate portfolio diversification, its merits are proven.

Getting Started With CRE Investing Has Never Been Easier


The CrowdStreet Marketplace makes a point to include a variety of different types of offerings across its platform to help investors build portfolio diversity as they continue to increase their real estate investments. CrowdStreet also provides investors with a single dashboard to track and manage those investments.

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This article was written by an employee of CrowdStreet, Inc. (“CrowdStreet”) and has been prepared solely for informational purposes. The information contained herein or presented herewith is not a recommendation of, or solicitation for, the subscription, purchase or sale of any security or offering, including but not limited to any offering which may invest in the geographic area(s) or asset type(s) mentioned herein, whether or not such offering is posted on the CrowdStreet Marketplace. Though CrowdStreet believes the information contained and compiled herein has been obtained from sources believed to be reliable, CrowdStreet makes no guarantee, warranty or representation about it. Any projections, opinions, assumptions or estimates used are for example only and do not represent the current or future performance of the subject thereof. All projections, forecasts, and estimates of returns or future performance, and other “forward-looking” information not purely historical in nature are based on assumptions, which are unlikely to be consistent with, and may differ materially from, actual events or conditions. Such forward-looking information only illustrates hypothetical results under certain assumptions.

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