The case for debt vs equity
This article first appeared in Costar.
Over the last 20 years, I have been involved in the management of a number of UK real estate funds. Relative return and absolute return; open-ended and closed-ended; equity and debt. I have also been fortunate enough to work through the tech boom and bust, the bull market that followed, the global financial crisis and the unprecedented period of near-zero interest rates thereafter, writes Ludo Mackenzie, head of commercial property at Octopus Property.
In this time, I’ve learnt that the key problem with direct property funds, whether relative or absolute return, is that the value of their assets is inextricably linked to market sentiment. Values will rise and fall with the cycles.
Relative and absolute return funds can offer good returns at the right times. Yet their limits are well documented.
Relative return funds simply try to beat their peer group, come rain or shine. The manager of a relative return fund will claim outperformance if he or she delivers -5% when the relevant benchmark delivers -6%. These funds give investors immediate exposure, and a good manager will do their level-best to deliver active management that beats the pack. Nevertheless, a negative return should not be regarded as a ‘good result’.
On the other hand, absolute return funds, usually closed-ended, will seek to deliver a positive return throughout their life span, regardless of how the market ebbs and flows. The problem is that it’s hard to swim against the tide. As we saw in 2007-2009, when sentiment turns and yields rise, asset prices fall. It’s pretty much impossible to maintain your target return in these circumstances. It’s all about luck of the vintage.
Over the years, leverage has become a key component for absolute return funds, with debt being injected into individual deals or at fund level.
As everyone knows, leverage can amplify returns. For better and for worse. An absolute return manager needs leverage to outperform their peer group when the market is rising. Without it, they simply won’t keep up.
This is great when the market is on the up. The problem is that when the market is falling, negative returns are amplified. Investors may then not only see their return target missed – they may actually see returns fall into negative territory.
We are at a point where equity returns have generally been good. The MSCI IPD UK Monthly Index has delivered an unlevered return of 9.1% over the last three years. The AREF Index of unlisted, open-ended UK property funds has returned 8.6% over the same period. Yet of course past performance is not a reliable indicator of future results.
The problem facing institutional investors now is that yields are close to 2007 levels and the consensus forecast from the Investment Property Forum is for lower returns going forward.
Certain sub-sectors will offer brighter spots, but generally speaking, the rational expectation is for returns to be disappointing, as yields stagnate and returns are driven primarily by rental income.
Against this backdrop, our expectation is that absolute return funds will struggle to deliver on target; relative return funds will plod along, and levered investors may suffer negative returns.
In this environment, debt funds offer a compelling alternative for institutions seeking a less volatile alternative to equity investment.
The key thing is that debt ranks ahead of equity. So, when an asset is sold, the debt must be repaid before the owner gets their equity and any profit. Depending on the loan to value ratio (LTV), the debt has a cushion to protect it from a drop in the value of the underlying asset.
Assume a loan at 70% LTV. In simple terms, the value of the asset could fall by 30% before debt capital is at risk. Assuming a 5% cost of enforcement, the UK average yield on UK property would have to rise from its current level to around 8.5% before the fall in value exceeds 25%. Yields were last at this level in 1993. By comparison, a 60% levered investor buying into the market today would only need to see yields fall back to 2014 levels to make a zero-total return.
The recent De Montfort Lending Survey showed that alternative lenders are growing their share of the UK commercial property lending market.This is because borrowers appreciate the speed, flexibility and customer focused approach of non-bank lenders.
Institutional investors are turning to the same lenders as a source of attractive and steady returns.
Taking into account the current point in the cycle, we expect investors to increasingly look to debt.
For journalists in their professional capacity only. Personal opinions may change and should not be seen as advice or a recommendation. We do not offer investment or tax advice. Issued by Octopus Property. Octopus Property is the trading name of Bridgeco Ltd (Reg No 6629989), Fern Trading Ltd (Reg No 6447318), Nino Ltd (Reg No 9015082), Octopus Property Lending Ltd (Reg No 7531926) and Octopus Co-Lend Ltd (Reg No 8913299), Registered Office: 33 Holborn, London EC1N 2HT, registered in England and Wales and Dragonfly Finance S.ar.l. (Reg No B189290) Registered Office: Parc d’Activité Syrdall, 6 Rue Gabriel Lippmann, L-5365, Munsbach, Luxembourg registered in Luxembourg. Octopus Property Lending Ltd and Octopus Co-Lend Ltd are authorised and regulated by the Financial Conduct Authority. Issued November 2017.