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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

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hurdle rates for real estate investment

Hurdle Rates For Real Estate Investment

Theory and Practice

RICHARD BARKHAM

September 2009

agenda
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
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 issues6
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
MARKET RISK FACTORS

Tenant quality:

Size

Sector

Multi-let

B

E

T

A

Location

Prime / secondary

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

specific risk factors
SPECIFIC RISK FACTORS
  • Depreciation
    • Technical
    • Functional
    • Locational
  • Supply / competition
  • Tax / legislative change
  • Ground conditions (for developments)
  • Construction cost overshoot (for developments)
the volatility approach11
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
the market structure approach19
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 Moody’s ratings
  • Transparency risk
    • JLL market transparency index
    • Converted to premium with range 25bps to 125bps
the market structure approach20
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
the market structure approach21
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
real estate risk premia by market
REAL ESTATE RISK PREMIA BY MARKET

100 basis points

Source: Grosvenor, 2009

target vs expected returns mid 2009 mid 2014
TARGET VS. EXPECTED RETURNS, MID 2009 - MID 2014

Expected returns

Target returns

Source: Grosvenor Research, 2009

target vs expected returns mid 2010 mid 2014
TARGET VS. EXPECTED RETURNS, MID 2010 - MID 2014

Expected returns

Target returns

Source: Grosvenor Research, 2009

conclusions and observations
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
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