As investors target proxies for income security, they neglect macroeconomic factors at their peril, says Shayla Walmsley.
It is a cartoon scenario: the man avoiding a puddle falls down a manhole. Schroders' head of property fund management Neil Turner suggested this week that investors were doing something similar: fixated on mitigating one kind of risk, they could be missing other big ones. He gave the example of investors concerned with income security focusing on covenant strength - and all but ignoring other asset-specific risks such as location and obsolescence. Turner told IP Real Estate: "I can't remember a time when the reliance on covenant strength has been so dominant in investor decision-making."
It may be that Turner's criticism understates the hierarchy of risks. Former Prupim strategist Paul Mitchell recently pointed in the pages of IP Real Estate to research showing a correlation between abnormal annual returns and "lease events", but not between returns and the property's fabric and location.
Yet among investors in Germany, not only lease length but also location acts as a proxy for income security. Thomas Beyerle, head of research at IVG, talking about the reluctance to consider secondary locations, claimed it was as much a psychological condition as an investor decision. While macroeconomic risks rather than asset-specific risks drive the market, investors fix on one side of the street rather than another, where there is no difference in (say) vacancy risk and no currency risk.
"You could almost look at it from a psychological perspective, rather than a risk perspective," Beyerle said. "You're talking about investors moving from Frankfurt to Freiburg, but the risk is too high for them, even if the decision to invest in a smaller city would mean higher yields and lower prices. The exit is the issue, and whether it is within the risk profile of the asset."
For Beyerle, the income-oriented focus on core and super-core assets is an indication that investors lack the sensitivity that makes rational risk assessment possible. "I get the impression that when an investor goes after a yield of 5%, they're investing on the premise that they will get their money back," he said. "They aren't looking at the portfolio management risk, but acting on the belief they will get the money back."
He added: "The idea that you can invest without any risk is absolute nonsense. But we have a situation with, on the one hand, a massive sum of money and, on the other, a limited core market. Now you see money pouring into Germany, but the money will vanish just as quickly. Safe havens sound good, but some of these investors, perhaps especially private equity investors, are effectively parking money, and it isn't correlated to a 10 or 20-year investment."
Simon Durkin, RREEF head of research for Europe, has suggested that one reason why investors are fixated with income is because it didn't create the last property bubble. It is the capital element that introduces volatility.
"Asset-level characteristics are critical and always will be," he said. "But the reason some investors are willing to pay 5% for City offices in what is historically a volatile market is because they're investing not for the short-term but for capital preservation."
The problem for income-focused investors is that income is only one part of the business plan for the asset. "That's what we're talking to investors about — not just the strength of the income stream, but also the exit assumptions and capital market influences," said Durkin. "The combination is what drives performance."
Yet an asset's exit plan is effectively a bet on a future market. A 10-year plan that involves exiting with X years of unexpired lease left to the seller may involve an educated forecast, but it is still a gamble on what the market will look like at a specific future point.
"Given the focus on income quality and duration, we should not lose sight of the capital market influence on performance and ultimate completion of the asset business plan and exit," said Durkin. "Having a robust process for understanding capital market drivers is essential to underwriting the deal."
It is not income per se that is at issue here, but an overreliance on a specific risk as a proxy for all risk. If the risks du jour are not exactly arbitrary, some have stuck in investors' consciousness more firmly than others. Turner is critical of the reluctance to use leverage when it makes sense to do so, for example, but said he believes most investors are sensible in their approach to debt at appropriate levels.
"High volumes of leverage would not be appropriate - but they would be expensive," he said. "Investor caution is understandable, but there is a sound logic to using leverage of 30% or 40% if you have a good piece of real estate and a good local platform to manage it."