Hurdle Rates For Real Estate Investment

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Hurdle Rates For Real Estate Investment

• Theory and Practice

RICHARD BARKHAM September 2009
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AGENDA

• Theoretical matters
• Three approaches we (sometimes) use at Grosvenor
• The volatility approach
• The risk audit approach
• The market structure approach
• Conclusions and observations
• Afterword dealing with development

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THEORETICAL ISSUES

• Risk is the dispersion of potential outcomes
  around the expected value (ex ante)
• Risk can be partitioned
• Market risk affects all assets and so cannot be
  eliminated through diversification
• Specific risk asset specific, uncorrelated with
  the market and does not contribute to the
  volatility of a portfolio.

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THEORETICAL ISSUES

• The dominant theme of modern finance is that only
  market risk (beta in CAPM) is rewarded
• Specific risk can be eliminated by
  diversification an is not rewarded
• No real evidence that CAPM applies in the
  property market
• Include specific risks in hurdle rates
• But weight market risks higher than specific
  risks.
• Financial markets research suggests that market
  risk (an assets beta) is governed by
• Operational gearing
• Sensitivity of assets cash flows to the business
  cycle.

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MARKET RISK FACTORS
Tenant quality Size Sector Multi-let
Location Prime / secondary
B E T A
Freehold or leasehold interest Gearing Review
patterns and break options Weighted average lease
length
Vacancy Current / expected as a of rent passing
Rental value Trend, cycle and shocks Relationship
to rent passing
Yield Initial / equivalent yield as of forecast
IRR
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SPECIFIC RISK FACTORS

• Depreciation
• Technical
• Functional
• Locational
• Supply / competition
• Tax / legislative change
• Ground conditions (for developments)
• Construction cost overshoot (for developments)

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THE VOLATILITY APPROACH
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THE VOLATILITY APPROACH

• Estimate (or engineer) the equilibrium
  relationship between risk (volatility) and return
  in the UK property market
• Create simulation models to project market
  outcomes over the next five to ten years
• Rents, yields, rates of default, costs
• Univariate time series models (ARIMA etc)
• Linked with appropriate correlations
• Subject base case cashflows simulated market
  outcomes
• Measure (standard deviation) the range of IRR /
  NPV outcomes from simulated cashflows
• Depends on market AND the income certainty of
  real estate cashflow
• Use the risk return line to calculate the hurdle
  rate

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RISK AND RETURN IN UK REAL ESTATE
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ORIGINAL DATA (highly filtered)
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THE RISK AUDIT APPROACH
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THE RISK AUDIT APPROACH Investment
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THE RISK AUDIT APPROACH Investment
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THE RISK AUDIT APPROACH Development
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THE MARKET STRUCTURE APPROACH
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THE MARKET STRUCTURE APPROACH

• Risk free rate
• UK ten year gilt
• Individual country rates leads to strange results
  e.g. Japan 1.3, Australia 5.3
• Country risk
• New York Stern University Risk premium based on
  Moodys ratings
• Transparency risk
• JLL market transparency index
• Converted to premium with range 25bps to 125bps

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THE MARKET STRUCTURE APPROACH

• Liquidity risk
• Based on turnover as share of total and tradable
  market
• Converted to premium with range of 50bps to
  250bps
• Business risk
• Based on volatility of rents
• Converted to premium with range 75bps to 125bps
• Depreciation risk
• Varies by sector based on academic findings
• Office high, retail lower
• Converted to risk premium 75bps to 125bps

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THE MARKET STRUCTURE APPROACH

• Income risk
• Security of income based on average lease length
• DTZ data, converted to premium between 75bps to
  125bps
• UK has a low income risk

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REAL ESTATE RISK PREMIA BY MARKET
100 basis points
Source Grosvenor, 2009
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TARGET VS. EXPECTED RETURNS, MID 2009 - MID 2014
Expected returns
Target returns
Source Grosvenor Research, 2009
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TARGET VS. EXPECTED RETURNS, MID 2010 - MID 2014
Expected returns
Target returns
Source Grosvenor Research, 2009
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CONCLUSIONS AND OBSERVATIONS

• Utilise the insights of finance theory, but
• Include allowance for specific risk, particularly
  for development projects
• Many different approaches
• horses for courses
• communication is important
• Hurdle rates should be contra-cyclical
• Process is as important as technique
• Business team buy-in (or coercion)
• Hurdle rates set independently

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AFTERWORD DEALING WITH DEVELOPMENT

• Developers have some very interesting ideas on
  risk
• Listen politely
• Market risk in development is much higher than
  investment
• But it can be hedged
• Specific risk in development is also very high
• Often very difficult to hedge or insure
• Needs to be priced

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