Determining the hurdle rate is more than just a box-ticking exercise. Be sure to combine the knowledge of acquisitions experts with the skills of risk analysts. Rob Martin and Richard Barkham report

Following one of the most severe commercial real estate corrections in modern history, investors are now turning their attention back to the investment opportunities offered by the asset class. Determining the appropriate ‘hurdle' rate - the minimum acceptable rate of return for transactions - is key to turning top-level allocations into investment performance.

The setting of hurdle rates was the subject of a recent seminar hosted by the Society of Property Researchers (SPR). Presented here is a summary of the material presented; the theoretical backdrop, some of the methods used to apply the theory to real estate and the challenges involved in turning theory into practice.

In the finance literature, the capital asset pricing model (CAPM) is used to determine the appropriate rate of return of an asset. The central theme is that markets will determine the price for an asset that reflects prospective risk and return. CAPM draws a distinction between market risk and specific risk. Market risk, also known as systematic risk or beta, affects all assets and cannot be eliminated through diversification. Specific risk however, is unique to each asset and is therefore uncorrelated with the market.

The dominant theme of modern finance is that only market risk is rewarded - as specific risk can be diversified away, investors cannot expect to be compensated for it. But data on the actual performance of property assets demonstrate huge variation in risk/return in a way that CAPM would not predict, driven in large part by the heterogeneity of the asset class; no two properties are the same. So for commercial real estate at least, in many cases, specific risk matters. Hurdle rates are conventionally constructed from a risk-free rate and market risk premium; for real estate, investors may also choose to add specific risk premia.

Strategists typically use nominal government bond yields as the risk free rate. They are assumed to have no default risk and an unbiased estimate of inflation rates across different time periods. The bond maturity can be selected to reflect the hold period the investor has in mind.

Owing to the relatively high transaction costs and long holding periods for real estate, one of the decisions individual investors need to make is whether to use current rates or a medium- to long-term average to prevent decisions being overly influenced by current market pricing.

There are a number of uncertainties which extend to the real estate cash flow relative to those of a bond that should be reflected in the risk premium, the critical areas being:
 

Rental value growth; Exit yield; Liquidity; Default risk; Void uncertainty; Depreciation/capital expenditure.


Beyond the macro level, there is a strong argument that risk premia should be adjusted to reflect the characteristics of different real estate sectors or regions - eg, City of London office rents are highly volatile and could be said to merit a higher risk premium for rental value than, for instance, French shopping centres. The consideration of rental growth patterns raises the broader question of whether hurdle rates should be cyclically adjusted - there is an argument that hurdles should be adjusted to reflect the stage in the cycle at which investments are made and hence the prospects for above or below trend returns.

Added to these considerations, from the perspective of multinational investors, there are inevitably a wider set of factors that become important when comparing opportunities across different jurisdictions. Most important among these are market transparency and governance, and political and currency risk.

We have noted the evidence that specific risk should be priced for individual real estate assets. This is particularly true for developments, which, since they are fully exposed to the spot rental market, have a higher risk profile than standing investments.
Other factors that can have major bearing on returns at the asset level include:
 

Microlocation - core or off-pitch, ease of accessibility, local externalities; Competing supply - local and regional, current and future; Specification and depreciation - technical/functional; Ownership structure - freehold or leasehold; Ground conditions (for developments); Construction cost overshoot (for developments).


Here the devil is in the detail. Calibrating the size of the premia that should be applied for these factors is both difficult and time consuming. The relevance will be greatest for investors engaged in higher-risk activities, development in particular, and those with less well-diversified portfolios.

In practice, the perspective of the individual investor is key in deriving the appropriate hurdle. Listed real estate and geared investors generally focus more on weighted average cost of capital (WACC), though the impact of leverage on the risk profile also needs to be reflected. Institutional fund managers are likely to focus more on the precise targets set out in their mandates, which are typically peer group benchmarks.

Time horizon is also critical. Retail funds are frequently highly geared to short-term performance, implying greater sensitivity to drivers of risk and return over one- and three-year periods. Other investor types, one of the most obvious examples being sovereign wealth funds, can have much longer investment horizons. Their hurdle rates are likely to give less weight to cyclical beta factors and set greater store by structural issues/changes such as governance, political risk and long-term economic and demographic development.

But hurdle rate processes can degenerate into mere box-ticking exercises. One way to avoid this is to ensure that investment processes are set up to ensure a full and frank discussion of risk takes place prior to placing capital in the market by making those responsible for hurdle rate setting independent of deal makers. Here the danger is that the process becomes too adversarial. The best hurdle rate processes succeed by combining the market knowledge of acquisition teams with the discipline introduced by experienced risk analysts.