The benefits of leverage are clear, but given property's changing risk profile how much is appropriate and for how long? Kiran Patel reports
Without doubt, over the last four to five years most managers/investors viewed debt on real estate as a way of enhancing return. The positive yield gap between income and cost of financing was the main draw. But in a lot of cases this narrowed very quickly and by 2005/06 it had all but disappeared. This clearly should have been a sign that leveraging real estate cannot be a one-way ticket to higher returns. But it is quite puzzling why real estate players continued to over-anticipate the benefits of leverage on total return. Real estate by nature is a cyclical asset. If things get exaggerated on the upside, there is an equal probability that it will be exaggerated on the downside. Was the increased volatility in returns really understood by managers/investors when they accepted the usage of debt?
Paradoxically, one reason why asset allocators look towards real estate is that it exhibits diversification benefits but also low volatility. Adding leverage to real estate does the reverse, it increases diversification, particularly to equities and, as we have seen, adds extra volatility. For example, it only requires a 20% fall in value on a 60% leverage property for the investor to make a 50% loss on its original capital. In addition, one has to question the economies of scale from a multi-asset perspective. On the one hand, pension funds and insurance companies are buying government bonds, that is, lending to the government for a nominal interest rate charge (in today's environment receiving less than 3% on a five-year eurobond) and, on the other hand, they are leveraging their real estate portfolios by taking on a liability in the form of debt (borrowing from the bank, senior lending at approximately Euribor + 2.5% margin, equating to an interest charge of about 5.25%). Clearly, the economies of scale do not work, particularly when you take into account all other debt costs, such as arrangement fees (1%) and costs associated with undrawn commitments (1.5%). Why not just decrease the fixed income portion and increase the real estate portion without the need for a higher liability (debt on real estate) which has a higher cost of capital.
Debt on real estate should not be seen just as a return amplifier. It has many other uses and therefore needs to be appropriately applied. First, real estate is a lumpy asset and debt in such a case provides spread/dispersion. Secondly, when investing across borders, debt can be used more economically than equity to structure and mitigate some tax losses. What levels are correct though? It has become common practice to assume that core portfolios would be leveraged at around 50-60%, value add portfolios at 60-65% and opportunistic strategies at 70% or more. But are these the right levels and how does the usage of debt vary over time? Real estate risk is never a static element. Property dynamics continue to change and evolve. For example, locational characteristics can change, lease lengths reduce, properties suffer from depreciation and tenant profiles can improve or deteriorate in quality. Therefore income quality and levels can be affected. Should the levels of debt not vary over time to coincide with the changing risk profile of property?
There is also the durational aspect of property cycles to consider. By nature they are getting shorter (driven by many factors - for example, improving transparency). In many cases, typical fund strategies with lives of seven years and in which debt is applied for that whole period do not sit comfortably, where across that duration you could get three to four years of rising incomes/total returns but also two to three years of declining or stagnating performances. It is not a given that the arbitrage (rental income exceeding the costs of debt financing) will remain positive throughout that whole period.
As a result of falling capital values, some players are struggling with loan-to-value (LTV) and/or income cover ratio (ICR) breaches on many of their properties/portfolios. In such an environment, one would expect deleveraging of real estate. But the reverse is true. In fact, outstanding debt to real estate is still rising as banks roll over performing, maturing loans where once they would have expected the principal to have been repaid (figure 1). At the same time, they are not taking action on loans in breach of covenants as this would lead to an immediate write-down on their balance sheet - something they would like to avoid in these times where adverse effects to tier 1 capital ratios are not welcome.
The problem is compounded further by the growth in opportunistic vehicles - managers who want to take advantage of some of the distressed selling and the new pricing levels being achieved. It is not unusual to hear quotes such as "a once in a lifetime buying opportunity". Several managers either have raised or are raising capital to take advantage of such situations.
We have also seen the emergence of real estate debt funds, approximately 30 funds that have strategies to purchase distressed (existing) real estate debt or purchase primary real estate debt (new loans) higher up the capital structure (junior pieces and/or mezzanine lending). This space has become available because many of the banks are not in the market to provide new financing. And with nearly all of these opportunistic debt fund offerings targeting returns in excess of 15% pa, the majority of which are leveraged funds, one has to question how much of that expected return will be delivered by the underlying fundamentals of real estate and how much is being placed on the shoulders of debt (at the fund level).
Despite the higher bank margin spreads, the arbitrage opportunity whereby property income exceeds the cost of financing is once again in positive territory (figure 2). In this low interest rate environment this will clearly be a lure for many to quote that real estate is back to being a self-financing asset and that leverage can enhance returns. But we should not forget the lessons of over-leveraging the asset class, some of which have not yet fully unwound.
Kiran Patel, global head of research, strategy and business development, AXA Real Estate Investment Managers