The experiences of real estate funds that geared their investments at the peak of the market have prompted some investors to reject leverage outright. But, as Ian Whittock explains, debt has a part to play

The single most important element influencing the returns on property investment funds is the management of debt. However, it is evident from these returns over the past three or four years that the implications of using debt in funds is not fully understood by many investors and fund managers.

In many cases actuarial consultants have used returns from directly held (ungeared) commercial real estate to advise institutional investors on an appropriate target real estate weighting. This weighting will be partly based on property's total return and risk expectations and partly on the diversification benefits commercial property has on a portfolio of different asset classes. The chief attractions of direct property are its stable income return, low correlation with other asset classes and its relative lack of volatility.

Unfortunately, there is a tendency for investors to chase returns. A good example of this is the activity following the cyclical high of 2004-06, when property investors were used to getting double-digit (ungeared) returns. At this point many investors had persuaded themselves that such results were sustainable and were no longer prepared to accept more typical returns of 6-8% per annum. Needless to say, there were plenty of property investment managers prepared to provide products offering returns in the range of 12-15% per annum. However, the only plausible way this could be done was by using debt to enhance the equity return.

Those adopting this approach soon found themselves to be victims of the law of unintended consequences. By trying to sustain cyclically high, ungeared returns, investors inadvertently adopted a much higher risk strategy during a period when the investment risk was rising sharply (as yields fall). Their geared investments would not provide many of the benefits the investor was trying to capture - frustrating the multi-asset strategy that gave rise to the property weighting in the first place.

This is not to suggest that investors do not use debt when investing in property, but they need to understand the nature of such investments and adopt a strategy that takes account of the risks.

Modelling the effects of debt on returns over a complete UK property cycle, and assuming a constant level of gearing, results suggest that the use of debt leads to a marginal increase in returns. However, when assessed on a risk-adjusted basis, the additional return is not sufficient to justify the significant increase in risk.

Capital values rise and fall during a typical property cycle, but the income return (on institutional quality portfolios at least) usually remains fairly robust. A successful leveraged investment strategy is usually based on investing when yields are relatively high and not after a period of strong performance when yields would be pushed down. For most investors this is counter-intuitive since they feel more inclined to take risks following a period of strong returns, rather than a period of weak returns (when yields have risen), yet many investors would agree that the lower the yield at purchase, the greater the risk and vice versa.

Losses usually occur when divestment takes place when yields are high and rising. This does not result from a decision by the investor, but from an infringement of the banking covenants which passes control of the investment to a lender more concerned about protecting the outstanding loan rather than the investor's equity. The risk is therefore about losing control of the exit point.

In a cyclical market, the level of risk is not a constant - so gearing levels should not be constant either but reduced as yields fall. I believe this strategy would reflect a deeper understanding of the implications of debt-financed investments in commercial property.
After the experiences of the last few years, the use of debt is not very popular. However, a strong case can be made for investors who do want to use debt.

Most commentators fall into one of the two camps when considering the long-term economic and investment outlook, which is largely based on how the western economies deal with sovereign and domestic debt issues. On the one hand, there are those who believe the government will moderately inflate the problem away. This is a consequence of the political difficulties associated with getting voters to agree to sufficiently tough austerity measures to produce a significant reduction in debt levels. There is also a view that it is better to avoid a period of deflation and its detrimental effect on the real cost of servicing the debt. This is considered by many to be more unpalatable than a period of moderate inflation.

On the other hand, there are those who warn we are heading for a period of Japanese-style debt deflation, which would have the effect of keeping interest rates low for a prolonged period.

In the first scenario, the argument for the use of debt is based on the fact that inflation is good for borrowers and bad for lenders. Higher nominal rates of rental and capital growth associated with higher rates of inflation more than compensate borrowers for the higher interest rate charged.

In the second scenario, if Japan is any guide, the only way to justify investing in institutional-quality stock is to use debt to take advantage of the arbitrage between low interest rates and higher (but still low by institutional standards) property yields.

A strong case for the use of debt over the medium term can be made under both these scenarios, although it would be prudent to build in sufficient safe guards to be able to withstand any short-term volatility. This is almost inevitable at some stage as we return to a more normal market environment, free of some of the policy supports in place.

Therefore, I would conclude that investors must be clear about the effect of debt in changing the investment characteristics of property and whether that remains consistent with their multi-asset strategy.

For those intent on using debt to promote enhanced returns, I would advise adjusting the level of debt as we progress through the cycle and, importantly, to use debt now rather than when the cycle is more mature.

Ian Whittock is CIO at ING Real Estate Investment Management UK