Gearing has done much to boost real estate fund performance during the boom years but the downturn has thrown the disadvantages of a highly levered strategy into sharp relief. Don't abandon debt, just understand it and use it wisely, say Chris Hoorenman and Maarten van der Spek


John Maynard Keynes once said: "Markets can stay irrational onger than you can stay solvent." In light of the current credit crunch, this quote is very much alive. A number of US banks have already failed and many of the big banks have raised huge amounts of equity to boost their balance sheets.

The current financial turmoil has again proved the dangers of investing in products with extensive use of debt. In particular, the lack of liquidity in a falling market can quickly lead to severe losses, when almost no one is buying and everyone is trying to exit the investment.The use of debt, commonly referred to as leverage or gearing, does much to accelerate this process.In the property investment fund universe it is customary to finance part of a fund's assets with debt to enhance returns, create a tax shield or increase the fund's size to benefit more from economies of scale and diversification.

This has boosted fund returns in past years to highly attractive levels. With the current uncertainty in financial markets and the global economy, and with several property markets in a slowdown, it might be worth reinvestigating the rationale for financial gearing. In this short paper we will first show the current use of leverage in the property fund universe, then we will demonstrate the impact of this leverage on risk and return. Finally, we will show what the impact is on fund level performance for different investment styles.

Market evidence
The average leverage within non-listed funds is 50%, meaning that on average half of the investments in these funds will be financed with debt. Figure 1 gives a more detailed view, broken down by styles and sectors. As can be seen from the graph, the riskier styles have higher gearing levels, which is in line with expectations in the real estate fund business. In fact, higher leverage is even part of the INREV style framework to help define funds as core, value added or opportunistic. It is interesting to note that in other investment industries, stacking risks by leveraging more volatile investments is far less common. In general, higher leverage is employed for low-yielding, low-risk strategies such as bond arbitrage, with little or no leverage being used in high-risk strategies such as investments in emerging market stocks. This is completely the opposite of real estate investment fund conventions.


Across sectors, the differences in leverage employed are small. However, the retail sector, which is generally considered to be the least risky, is also leveraged the least, while the more cyclical office and industrial sectors show the highest leverage. Again, this sounds counter intuitive compared with other investment industries.
Finally, further analysis shows that there is a general upward trend in target leverage levels within property funds. Gearing levels used to average about 30% for funds launched in the 1980s, averaged about 40% in the 1990s and now average about 50%.

The return impact of leverage
In the past decade, as a result of the low cost of debt and high returns on property, the risk of using leverage has paid off well, as it enhances fund returns when the cost of debt is lower than the return on property. On the other hand, when the cost of debt is higher than the return on property, fund returns suffer. Figure 2 shows the IPD UK all-property return and the lending rate over time. The orange line shows the leveraged result over time of an investment with 50% debt. It can be clearly seen that a leveraged strategy worked especially well for a property portfolio over the past ten years (except 2007) and before that period the results were rather mixed. It will be interesting to see how this effect progresses in the coming years when property returns are expected to be lower and lending rates higher.

Over the full period, the total return on direct property was 10.7%, while a portfolio investing in direct property with 50% leverage generated 13.4%. This example clearly shows that, in the long term, leverage can pay off. It is very interesting to look at how leverage would affect returns in the current market. Assume that a French office fund invested roughly the same as the IPD. The income return on that portfolio is therefore currently 5.8%. Let's further assume that rents only grow with inflation (due to underlying contracts and in France this is based on the construction cost index). The loan to value ratio is 50% and the cost of debt is 100 basis points above the risk-free rate of 4.8%. Below, three scenarios for 2008 returns are shown: (i) a market where yields don't move out, (ii) a market where yields move out by 60bp, which is approximately what French office derivatives are currently implying and (iii) an outward yield movement by 60bp and inflation increasing to 6%. The example clearly shows the added value of gearing in stable or positive markets. However, when markets are falling, the gearing amplifies the negative effect on the return. Instead of losing 1.5%, the fund loses almost 9% due to the leverage effect (in the second example). On the other hand, the third example presents the positive short-term impact of inflation. Higher inflation will compensate for the loss in value in the current market, showing the benefit of a real asset.

The risk impact of leverage
While leverage seems to result in a long-term additional return, it is not without risk. When property market downturns occur, it is not the debt provider that will have to absorb the losses. In the case of 50% leverage, a loss will have twice as much impact on equity than in the case of an unleveraged investment. All losses are paid for with equity until, ultimately, there is no equity left. Considering the relatively low volatility of the property market, it is unlikely that a fund with 50% leverage will lose all its equity, as this equates to a decrease of 50% in property values. However, the risk swiftly increases with higher leverage ratios. Figure 4 shows how fast the risk increases with different levels of leverage. For instance, the use of 80% leverage means that risk is increased by 400% or, in other words, a drop in property value by 20% will wipe out all equity.
Due to the increased risk related to higher leverage levels, banks also ask a higher risk premium, which leads to higher financing costs. Very high levels of leverage may therefore not only be too risky but also too costly, for example when the cost of debt equals the return on property, leverage becomes useless or even hurts returns.

Refinancing
Besides the risk that leverage adds to the overall performance, it generates a refinancing risk on maturity. As interest rates are moving constantly, a different interest rate on maturity can be expected. A lower interest rate will make refinancing easier and cheaper, but risks increase when interest rates are rising or property values are falling. Because of falling valuations, leverage levels will rise and this will prompt banks to demand a higher interest rate on their loans since they are deemed riskier than before. But the reluctance of banks to lend money might also be related to events outside the direct property investment industry. A general repricing of risk might occur, which will also have an impact on the cost of borrowing on property loans.


A good example of this situation is Centro Properties Group, an Australian listed property company. It became a victim of the sub-prime crisis fallout when it had to refinance its short-term loans. Management had planned to pay off this short-term debt by selling long-term debt through CMBS markets. However, the cost of capital went up and short-term debt could not be replaced easily because of the crisis. The dividend was cut and the share price plummeted by more than 90%.

Hedging interest rate
Fixing the interest rate on debt for the duration of the fund will mitigate some of the cash flow risk since payments are predictable and income returns tend to be fairly stable. However, it is very important to note that it does not mitigate the risk on the invested equity. A 50% leverage level will still double the volatility of an investment, even if the interest rate on debt is fixed. Furthermore, when leveraged, vacancy risk becomes a bigger issue. Whether interest rates are fixed or not, a drop in income because of increased vacancy can also lead to a cash flow deficit.

Risk return profile of private real estate funds
When investing in private real estate, an investor has a couple of possible ways to invest. The two most obvious are direct property and real estate funds. Direct real estate can be measured by the IPD benchmark and no gearing is involved. Real estate funds are measured by INREV (note: this is not a benchmark) and generally use leverage.
When choosing one of these products, one should be aware of the differences in risk-return profiles. As there is no long-term data on the performance of unlisted real estate funds, one can only replicate the historical performance by using direct real estate returns and adding leverage.


If we take the average leverage used by unlisted funds per investment style (see figure 1), we can estimate the risk-return profile of these funds including leverage. The risk and return assumptions have been loosely based on data for the Netherlands. Returns are set in accordance with future market expectations (for bonds 4.5%, direct real estate 6.75% and equity 9%) and the risk for each asset is based on a diversified portfolio, accounted for by taking benchmark data series. Furthermore, the assumption is made that the riskier funds do not create any additional value over direct real estate, so that the higher return is a direct result of higher leverage. We have also not taken into account the fact that a skilled active manager can add additional value. Finally, it is important to note that tax benefits are also not incorporated. The graph below pictures the risk-return profile of bonds, equity and direct real estate, together with the three real estate investment styles - core, value added and opportunistic, using the corresponding leverage levels.


 The three different real estate investment styles noticeably have their own risk-return profiles. An interesting observation is that using approximately 60% leverage results in a risk profile similar to investing in the stock market. Furthermore, real estate returns would be higher if value-added activities, such as refurbishments and redevelopments, and tax benefits were taken into consideration. In conclusion, the current credit crisis has led to a repricing of risk in the financial markets and higher interest rates as banks are rather reluctant to lend money. At the same time, property yields are rising in most countries and returns in the coming years are expected to be below average. The question arises whether leveraging property investments is a wise course of action under these circumstances.


Investment managers or consultants that use direct real estate data in their allocation processes on an unleveraged basis should beware, as investing in real estate funds is mostly accompanied by the use of leverage. When the allocation model is not adjusted for gearing, the portfolio risk is underestimated. Especially in a market where leverage plays a critical role, understanding the impact on risk and acting on this is important.
We believe that for investors with a long-term investment horizon, leverage should be beneficial. However, they should always consider the additional risk and, with Keynes's warning in mind, determine if they are able to sit out a short-term crisis.

Maarten van der Spek is director of research and strategy, continental Europe at ING REIM
Chris Hoorenman is senior research analyst at ING REIM