Hurdle Rates For Real Estate Investment - Nimbiz hurdle rates... · RISK AND RETURN IN UK REAL...

Hurdle Rates For Real Estate

Investment

Theory and Practice

RICHARD BARKHAM

September 2009

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

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.

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 asset’s beta) is governed by:

– Operational gearing;

– Sensitivity of asset’s cash flows to the business cycle.

MARKET RISK FACTORS

Tenant quality:

Size

Sector

Multi-let

Freehold or leasehold interest

Gearing

Review patterns and break options

Weighted average lease length

Rental value

Trend, cycle and shocks

Relationship to rent passing

Yield

Initial / equivalent yield as % of

forecast IRR

Vacancy

Current / expected as a % of rent

passing

Location

Prime / secondaryB

E

T

A

SPECIFIC RISK FACTORS

■ Depreciation

– Technical

– Functional

– Locational

■ Supply / competition

■ Tax / legislative change

■ Ground conditions (for developments)

■ Construction cost overshoot (for developments)

THE VOLATILITY APPROACH

Page 10

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

RISK AND RETURN IN UK REAL ESTATE

0%

5%

10%

15%

20%

25%

30%

0% 5%

10% 15%

20%

25%

30%

Standard Deviation

Re

qu

ire

d R

etu

rn

Current Hurdle Rate (rf = 3.93%) Risk Free Rate FTSE 100 FTSE Real Estate Gilts UK IPD All Property

Core

InvestmentsValue Added

Opportunities

Speculative

Development

ORIGINAL DATA (highly filtered)

y = 0.6699x + 0.0849

R2 = 0.4687

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

0% 3% 5% 8%

10%

13%

15%

18%

20%

23%

25%

28%

Standard Deviation of Returns

Ave

rag

e T

ota

l P

rop

ert

y R

etu

rn

Property Returns for Selected Years

THE RISK AUDIT APPROACH

Page 14

THE ‘RISK AUDIT’ APPROACH: Investment

Contribution to broader estate management goals

Difference From WACC

WACC

All Project Hurdle Rate

Non-Market Risk Factors

10 basis points for every 5% of depreciation riskDepreciation Risk

20 basis points * grade of location (1=hi to 10=lo) * % unlet

20 basis points * grade of property (1=hi to 10=lo) * % unlet

100 basis points * (1 / position in cycle) * % unlet"Leasing Risk

50 basis points * passing rent –ERV (as %)

10 basis points * (1-chance of replacing tenant in 6 months)

10 basis points * average grade of tenant

5 basis points * grade of location (1=hi to 10=lo)

5 basis points * grade of property (1=hi to 10=lo)

100 basis points * (1/weighted average lease length)

20 basis points * % annual rent from top three tenantsTenant Risk

5 basis point for each 25 basis points below long run average

5 basis points for each 1% annual yield volatilityExit Yield Risk

1 basis points * % chance of unforeseen cost increaseCost Risk

5 basis points for every 1% annual rental growth volatility

5 basis points * position in cycle (1=trough to 5 = peak)Rent Risk

Yield on 10 year giltRisk Free Rate

Method of MeasurementHurdle Rate Factor

THE ‘RISK AUDIT’ APPROACH: Investment

0.2%

7.5%

8.25%7.65%

nana0.00%

nana0.00%

0.80%0.8%

0.04%0.04%

0.04%0.04%

0.10%0.10%

0.33%0.33%

0.08%0.08%

0.14%0.14%

0.10%0.10%

0.10%0.10%

0.20%0.20%

0.20%0.20%

-0.08%-0.08%

Monetary conditions0.36%0.3%0.06%

0.05%0.05%

Double dip recession1.04%0.3%0.74%

0.05%0.05%

4.70%na4.70%

ExplanationFinal ScoreModifierRaw Score

THE ‘RISK AUDIT’ APPROACH: Development

Equity Only

All Project

+0.5% - years between planned end date and guaranteed end date

-0.01 for every 1% of fixed-interest gearing

-0.01 for every 1% of non-recourse gearing

+ 0.1% for every 1% of gearing (includes mezzanine debt)Debt Risks

+0.5% - time between planned end date and guaranteed end date in %

+ 0.1% for every 1% chance land acquisition will go over budget

+ 0.1% for every 1% chance of not achieving planning permissionNon-Market Risk Factor

-0.5% for every 10% of scheme let

+ 0.1% for every 50,000 ft of potentially competing space at compeletion

+ 0.1% for 50,000 sq. ft. of space to let

+ 0.01% for every level between town and top of retail hierarchy

+ 0.2% for every 10 unit shops to let

+ 0.1% for every level chosen anchor is below premier storeLeasing Risk

+ 1% / number of years over which project completes

+ 0.1% for every 0.1% of market yield volatility

+ 0.1% for every 0.1% assumed yield below long run averageExit Yield Volatility Risk

-1% for GMP or other guaranteed cost procurement route

+ 0.5% for incomplete design

+ 0.2% for unknown / unused contractor

+ 0.2% for potential archaeology

+ 0.5% for previous industrial use

+ 0.2% for previously developed site

+ 0.1% for every separate building

+ 0.1% for every 50,000 sq. ft. of construction

+ 0.1% for every year of constructionCost Volatility Risk

+ 0.1% for every 0.5% of standard deviation of annual rental growth

+ 0.1% for every 0.2% bp assumed rent growth above long term trend growthRent Volatility Risk

Yield on 10 year giltRisk Free Rate

Hurdle Rate Calculation

THE MARKET STRUCTURE APPROACH

Page 18


■ 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 Moody’s ratings

■ Transparency risk

– JLL market transparency index

– Converted to premium with range 25bps to 125bps


■ 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


■ 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

REAL ESTATE RISK PREMIA BY MARKET

Source: Grosvenor, 2009

100 basis points

0 1 2 3 4 5 6 7 8 9 10

NYC Office

London Retail

LA Retail

DC Office

London: City Office

Chicago Office

Sydney Office

Denver Retail

London: West End Office

Phoenix Retail

Manchester Retail

Paris: CBD Office

Brussels Office

Madrid Office

Milan Office

Madrid Retail

Lisbon Retail

Hong Kong Retail

Tokyo Office

Shanghai Office

Beijing Retail

country risk

transparency risk

liquidity risk

business/volatility risk

depreciation risk

income risk

0%

2%

4%

6%

8%

10%

12%

14%

16%

0% 2% 4% 6% 8% 10% 12% 14% 16%

TARGET VS. EXPECTED RETURNS, MID 2009 - MID 2014

Target returns

Exp

ecte

d r

etu

rns

Source: Grosvenor Research, 2009

0%

2%

4%

6%

8%

10%

12%

14%

16%

0% 2% 4% 6% 8% 10% 12% 14% 16%

Shanghai retail

London West End office

San Francisco retail

LA retailUK retail

Sydney officeLondon City office

TARGET VS. EXPECTED RETURNS, MID 2010 - MID 2014

Target returns

Exp

ecte

d r

etu

rns

Source: Grosvenor Research, 2009

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

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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