As real estate prices rise, attention is turning to rental income - where many potential pitfalls await. So has the time come to systematically assess global real estate income risk? Simon Marx reports
The international flow of capital seeking a home in real estate continues to grow. As competition for limited stock forces up prices to uncomfortable levels, agents are recording transactions at seemingly unprofitable yields. Intent on investing the capital which they raised all too easily, funds are diligently seeking out the next opportunity. With overpriced offices and shops in western Europe, this invariably takes the form of a new geography (Ukraine, Turkey, Vietnam) or new sector (student housing, nursing homes). Indirect investment has also benefited.
Within emerging economies, the real estate market is often immature and so the investor accepts a significantly higher risk. Such countries may bring with them political instability, as well as hurdles to conducting business. Investment invariably requires partnership with a local developer. There are also more fundamental risks; fast growing economies in eastern Europe may seem attractive but output or employment growth is often from a low base. Long-term emigration and unfavourable demographics cannot be ignored. Real estate markets are often small and do not provide the large foreign investor with the necessary liquidity to exit within an acceptable time frame.
New sectors can be equally immature, although Europe would do well to look to more forward-thinking markets such as North America or Australia, where specialist investors are already operating in niche markets. However, when investors shift towards subsectors such as infrastructure, it begs the question as to whether this is indeed real estate or another asset class altogether.
There is no doubt that opportunistic investors looking to new markets are accepting higher levels of risk than previously. Risks surrounding high levels of gearing have been exacerbated by the recent rises in interest rates. High risk being the very definition of an opportunistic investor, however, suggests that there is little extra cause for concern. It is the institutional investor who seeks to acquire low risk assets that is worse affected. Heightened risk sends these players running for safe ground, targeting prime buildings in established markets. They begrudgingly accept that a high-profile flagship store or a new office building in the centre of town will offer the safest return despite yields well below the cost of borrowing. Given the low yields, it is generally accepted that prices cannot keep rising at the double-digit growth of recent years. And so the market turns its attention to the other area with room for growth: income.
Unimpressive economic growth has meant that the recovery in the occupier markets since the downturn in 2001/2002 has been steady but slow. Rents have not grown as rapidly as was initially expected. In many cases, extremely low levels of supply in central locations has led to a rise in prime rents, but this is typically not transferred to the rest of the market.
It can be argued that investors are placing an unusual amount of trust in prospective rental growth. This strategy may pay off in faster growing countries, such as Spain, the UK or Ireland. Rents in the rest of Europe, however, give some cause for concern.
Monitoring prime rents can be misleading to the mid-sized investor. Average rents are more representative and forecasts suggest that average rental growth may be less than 2% per annum over the next five years. This is almost certainly not sufficient to maintain total returns at the exceptional levels of recent years. This is also a worry to banks, who are lending record levels of capital to finance these transactions and are also securitising real estate debt at an impressive rate as commercial mortgage backed securities (CMBS).
Who pays the rent? The tenant group which so often forms the majority of the rental income, yet is overlooked by many rating houses, is the small to medium sized company. Shopping centres or multi-let buildings, for example, typically comprise many private businesses or sole traders which are not obliged to publish financial statements of any kind. CMBS transactions are often based on the income stream of only a handful of tenants. There is evidence to suggest that as much as three quarters of rental income involved in CMBS transactions is from non investment-grade (and therefore unrated) tenants.
Furthermore, working closely with landlords and underwriters over a number of years reveals an alarming trend; many of the names on leases are to subsidiaries or shell companies. Much work has to be done to identify exactly who is paying the rent and, critically, who will underwrite the rent should the tenant default on payment or go into administration. Investors and lenders need to quantify the investment risks associated with buying or lending against commercial property assets.
Rental income is a substantial part of the investor or lender's return and becomes even more important in a rising market. For example, in a single year, a UK company leasing 50,000 ft2 at £45 /ft2 per annum (€710/m2) pays £2.25m (€3.32m) in rent. At the lease renewal three years on, such a tenant could see his/her annual commitment rise to £2.6m. And so at a fundamental level, risk analysis begins with the tenant, and critical to this is the likelihood of default on rental payments. These probabilities can be calculated based on historic evidence.
Outside the UK, commercial property leases tend to be shorter and more flexible. This may reduce the potential losses for the landlord, but income risk analysis should nonetheless form part of the bargaining strategy when purchasing a property. Being able to monitor tenant risk across countries is also of vital importance, given the globalisation of the financial and real estate industries. The success or not of a Japanese conglomerate may have significant repercussions on major tenants in London's City office market.
Given the size of some institutional investors, keeping track of tenant covenants can be complex. Ratings are determined based on a wide variety of information often not available to the general public, including payment performance that is updated in real-time. Global lenders and portfolio managers will acknowledge that keeping track of tenants on new, renewed or expired leases necessitates regular updates.
There are two further stages to analyzing risk over and above a standard company rating. By including information on the tenant's lease and on the real estate market in which the property is based, one dimensional tenant rating is given breadth and depth.
The first stage is to analyse the real estate market, based on a number of key real estate factors, such as rents, returns and vacancies, both historic and forecast. Local demographic and economic forecasts can also be entered into the equation.
Understanding spending habits, population shifts and employment trends in a town, for example, will give a better view of the performance of a local high-street shop than a credit rating of the company at a national or international level. Furthermore, buying into a CMBS which is based on tenants in closely-correlated industries may be riskier than one based on a diverse tenant base. Combining tenant and market ratings can only enhance the investor's decision-making process.
The second stage of the process is to determine the efficiency of the lease, as its negative effect on income may be considerable, in spite of a strong covenant. The investor should take into account the rent passing, the term of the lease and the timings of break clauses. A risk-adjusted future cash flow is then plotted and an IRR generated.
Linking the lease efficiency with market performance and tenant risk gives the investor or lender a comprehensive understanding of income risk and places them in a much better position to monitor and manage tenants, as well as maximise income streams across an international portfolio. This should also be part of the investor's due diligence prior to acquisition of a real estate asset. As the real estate market moves away from traditional bricks and mortar and adopts the characteristics of bonds or other financial asset classes, the savvy investor must seek to quantify and rate the performance of its income stream.
