Leverage had ‘horribly damaging’ impact on fund performance in downturn: ULI

The use of leverage had a ‘horribly damaging’ impact on property fund performance in the recent market downturn, new research from the Urban Land Institute (ULI) shows.

The negative impact of leverage was greatest for opportunity funds which showed the highest level of underperformance in the 2001/2011 period compared to core and value-added funds. According to the study, gearing led to 2.2% lower returns per year for every 10% of debt in a fund, equivalent to 13.2% per annum for a 60% leveraged investment.

The negative impact of leverage was also evident among value-added funds, which typically have more than 40% but less than 60% gearing and aim to generate some of their returns through active asset management. These funds outperformed the market between 2001 and 2007, but significantly underperformed the market between 2008 and 2011. The research demonstrated that every 10% of leverage within a fund reduced annual returns by 2%.

Core funds, which typically have little or no gearing and invest in prime assets, performed the best of the three types of investment vehicles and closely tracked the underlying IPD market index until 2009. Since then they have underperformed the wider market, probably due to the impact of capital flows into and out of open-ended funds. Over the whole period, leverage has accounted for a 1.1% reduction in performance for every 10% of debt in a fund (where debt is expressed as a percentage of GAV).

Commenting on the report, Professor Andrew Baum, academic fellow of ULI Europe and one of the authors, noted that the performance of property funds over the past decade is a complex picture and that returns had been influenced by a range of factors, including fund vintage, style and structure. ‘However, the asymmetric effect of leverage, horribly damaging in the downswing, has had a huge impact on investor returns and value that has been created by intelligent asset management has in many cases been destroyed by the way in which the fund has been financed.’

The report also found that the selection of the right fund manager was critical for investors. There were significant differences in the performance of funds not only from year to year, but also across managers within years.

The report is based on the performance of 169 European property funds using INREV and Property Funds Research (PFR) standards of core, value-added and opportunity funds to distinguish between investment styles and risk profiles. The research evaluated the extent to which these funds’ returns were driven by outperformance through skillful fund and asset management (alpha) and how much was determined by property investment risk including leverage (beta).