The sovereign debt crisis is undermining the concept of risk-free rate of return. What does this mean for RE markets? Pirkko Juntunen asks

The concept of the risk-free rate of return has for decades been the backbone of financial modelling and the starting point of portfolio construction. The idea, however, is slowly being eroded as government bonds are no longer seen as immune to default. The crisis in the euro-zone, some argue, is rendering the concept of the risk-free rate obsolete.

Even before the European sovereign debt crisis escalated at the end of last year, S&P's downgrade of US government bonds earlier in 2011 had brought to the fore the fact that even the most reliable government may default.

A study by Fidelity Worldwide Investments and Greenwich Associates shows that institutional investors in Europe are abandoning the concept of the risk-free rate and are looking at alternatives for managing their investments. But what are these alternatives and how does this affect asset allocation decisions pertaining to real estate? Is property a viable alternative to government bonds for pension funds looking for stable income to match liabilities?

Many would argue that the risk-free rate is useful as a theoretical concept and a necessity for the use of financial models, and will therefore continue to be used in the absence of an alternative. At the same time, it has its limitations - just because something works well in model does not mean it represents an absolute truth. Investors use additional factors and indicators in their models to achieve more accurate pricing data. Discarding the base of financial modelling is unlikely to be a helpful reaction and would be akin to throwing out the baby with the proverbial bath water.

Simon Durkin, head of research in Europe for Deutsche Bank Asset Management's real estate division RREEF, says abandoning the risk-free rate would lead to confusion and not just in the real-estate sector. "We need something to measure risk against and if it is not a perceived risk-free rate, then what? If everyone were to use different numbers, then deals would be extremely difficult to price," he says. "The risk-free rate is fundamental to pricing. Markets are cyclical and unpredictable and there will always be uncertainty but, over time, markets revert to long-term averages. Certain government bonds may no longer be completely risk-free, but we have to use a relevant rate as a baseline."

Milan Khatri, global property strategist at Aberdeen Asset Management, agrees. "The sovereign crisis and US downgrade has brought these issues to the fore, but bond yields have never been truly risk-free. Capital values have and can fluctuate significantly, such as in the 1970s."

Stefan Wundrak, director of research at the property arm of Henderson Global Investors, says that within the euro-zone it is possible to focus on a range of countries and avoid those identified as being poorer in quality. "Northern European countries can be used as a benchmark for the entire euro-zone and then on top you add other risk factors."

Wundrak says using AAA-rated bonds as the base-rate would be even more artificial and would not be risk-free either. "Corporate bonds may be a good proxy for low-risk assets, but models need a risk-free rate and in countries such as the UK and Germany this still works," he adds.

Ben Habib, CEO at First Property, does not believe the risk-free rate needs reassessing, because governments such as the UK and the US can print their own money and so have room to manoeuvre. "There is not a remote chance these countries will default," he says, adding that there are still risks, such as changes to the interest rates, which is nothing new.

Graham Barnes, senior director at CBRE, agrees with Habib in the sense that those countries that can print their own money are not in the same boat as the euro-zone nations, which in effect are borrowing in foreign currency. "This is worse than the gold standard because you are borrowing in someone else's currency - but one that does not belong to anyone," he says.

Barnes also argues there is no other option other than the risk-free rate of return, although investors have to ensure they use a rate that is appropriate. "Some use the Euribor as a proxy for short-term, risk-free rate, or some use the swap curve for long-term rates. But then there is the question of whose credit is assumed in the swap price? In screen prices, this is generic bank credit, which had been deteriorating. Another option is to use an index of government bonds, an average. You just have to be pragmatic," he says.

Currently more risk
Paul McNamara, head of research at Prupim, the real estate fund management arm of Prudential, says: "Currently there is more risk than normally is. But how does this affect the long-term outlook on risk-free rates? Long-term investors have to amortise the risks and get a composite rate, rather than adopting draconian changes in perpetuity."

Prupim continues to use the notion of a ‘least risk' rate as a foundation for pricing models. Mostly, this relates to government bonds. However, McNamara notes that: "Historically, government bonds have never been risk-free; look at Russia and Argentina to name a few in recent memory." Other factors such as return expectations and levels of liquidity are also important considerations, he adds.

In the current environment, where country risk can be above that of corporate risk, investors may decamp to using corporate bonds as the base rate with adjusted risk premiums. "The problem is that, if you do so, you need to adjust your risk premium for the fact that you have corporate risk already in your tenants," McNamara says. Others may move to using safer-haven sovereign bond rates, adding the currency risk premium. "Of course, the current environment has led to some head scratching for us," he adds.

Edwin Meysmans, managing director at Pensioenfonds KBC in Belgium, agrees, saying that pension funds have to continue investing and looking for income. The €1bn pension fund of KBC recently underwent an ALM study, still using the risk-free rate of return but with reduced expectations for government bonds. "German bonds do not cover the level of inflation any more. Our exposure to PIIGS countries has been fairly low but we do have Belgian bonds, so what is the alternative, where do we put our money? We cannot afford the 45% losses that equities have given, so property is an alternative," he says.

Pensioenfonds KBC decided to increase its real estate and infrastructure allocation to 12.5% from 10% as a result of the ALM study. "It is real assets and there is reasonable appetite for real estate. We are now focusing on a different category of real estate and are investing in non-listed real estate funds because the listed category has too much equity-like risk and correlation to equity volatility," Meysmans says.

"We are looking for income. We want a clear stream of income every month, or every quarter, and look less at the capital value appreciation. This is an inflation-linked income. A return of 8-10% and yield of 5% gives us a 3-5% appreciation where we can see the income," Meysmans says.

The desired investments are yield-driven ones with long-term leases with steady tenants. "We like retail spaces, as they have done well in the downturn and not depreciated as much as the office sector. There are also fewer claims in the retail and residential space. Tenants do not constantly demand lease reductions, upgrades in terms of energy efficiency and equipment, which is often the case with office space."

The exposure challenge
However, the lack of available stock is holding back allocations. Real estate pricing might be attractive relative to bonds, but the market is simply not big enough to replace government bonds and is not the solution to all of the problems faced by pension funds. "Good quality property offers sustainable income and, at current pricing, good value," Barnes says. "But the availability is a challenge and could force investors lower down the quality scale, which changes the risk profile. Legal & General is one of the most active UK players and is reported as having conducted nearly £1bn of purchases last year. This can be compared to government bond markets in which, for example, Spain raised €10bn in one hit this month."

Hermann Aukamp, CIO of real estate at the pension fund for doctors in the North Rhine-region, Nordrheinische Ärzteversorgung (NAEV) says the limited supply in the real estate sector means the fund is not looking to increase its 11% allocation, out of which two-thirds is invested in Germany and one-third in Asia, Europe and North America. "Most pension funds and insurance companies would like to increase their allocation into alternatives such as real estate but the question is how to do it," he says.

"In reality, only a fraction of the real estate market is available to institutional investors because they invest in core and prime assets. The remaining 85%, the commercial sector in particular, is untouched because of risks involved, making it hard for institutional investors to increase allocations significantly or particularly fast."

NAEV is currently looking at other alternatives to real estate, including infrastructure. "I think we will see more problems with financing in the real estate markets again this year, but in due course I expect that allocation into real estate will increase," Aukamp adds.

Even so, Aukamp does not see the erosion of the concept of the risk-free rate of return as being a major hindrance in allocating to real estate. "The fact is, there is no alternative to using the risk-free rate of return as a basis but, of course, in reality you only use it as a measure of certain government bonds, such as Finnish and German," he says.

Aukamp cites the real estate allocations of Swiss pension funds, which are often more than 15% and have been high for over a decade because of the low-interest-rate environment and the rise in house prices. "The capital appreciation has further increased demand, but the question is whether the Swiss model is the way for other countries, or if it will remain an exception," he says.

NAEV recently decided to invest in a US real estate fund, focused on the core office space in New York, Boston and Washington DC, in a bid to diversify the portfolio.  Aukamp says the pension fund is also keeping an eye on Paris and the Nordic countries and would be interested in the UK should opportunities arise. The most important factors for NAEV when considering adding investments are location and tenant quality.

The property professionals interviewed agreed that the performance is yield-driven, with relatively stable income. Price hikes seem to be less of a worry for long-term investors searching for income.

Sarah Bate, director of research and investment strategy at Mayfair Capital, says investors are increasingly demanding that downside is written in, which was not necessarily the case in the past. "It is all about not taking unnecessary risk but getting reasonable yield. Everyone is now looking for income," she says.

In today's market environment, investment process is key and investors must factor in tenant demand, default rates, key drivers in tenant sectors, as well as long-term economic and fiscal drivers and prospects. "There is not a one-for-one relationship between bond and property yields," says Khatri.

Khatri argues that southern European market capital values have not corrected fully yet. Banks in the region are getting significant support from the European Central Bank and, as a result, fire sales have not happened on a large scale. "Investors are focusing on core assets, which has led to prime assets becoming overpriced, and this is likely to persist in the short term. Investors need to think more broadly and not only target prime assets. At this point of the property cycle, second-tier locations with good fundamentals present better opportunities after accounting for risk."

Habib also warns against buying prime and core assets, particularly in London where small movements in interest rates could leave investors vulnerable and where yield rates are not high enough to offer protection. "London values are volatile and it is overvalued," he says. "London is special but it is not unique and the financial services sector is in turmoil. People forget that in 1991 house prices collapsed and did so again in 2007-08." Habib is overlooking London in favour of regional cities in the UK, such as Birmingham and Newcastle, as well as retailers that have faired well during the crises, such as discount-focused stores. "The likes of Poundland, Primark and H&M are set up to deal with dire economic circumstances," he adds.

However, James Thornton, CIO of Mayfair Capital, believes that the further away from London and the south east, the weaker the demand is as the economic slowdown bites. "We would buy away from London if the quality is right and long-term leases are available. You need forensic due diligence in every decision," Thornton says.