ANALYSIS

Does less leverage mean lower returns for listed property?

Ritson FergusonThe financial crisis has put an end to the excessive use of leverage by real estate companies, and the prospect of distressed assets presents opportunities for pension funds. Kristen Paech discusses the outlook for the sector with Ritson Ferguson, CEO and chief investment officer of ING Clarion Real Estate Securities.

Real estate companies are recapitalising worldwide, with around $41 billion raised since the beginning of the fourth
quarter of last year.
In doing this, most have addressed near-term debt maturities and reduced leverage to more manageable levels.

Leverage has been decreased to 45 per cent, from peak levels of about 51 per cent, according to ING Clarion Real Estate Securities.

However the recent pullback has reset valuations to multi-year lows, and the prospect of distressed assets presents opportunities for pension funds.

Approximately $200-300 billion of commercial real estate loans in the

US alone are due each year from 2009 through 2013, and many companies that borrowed 70 per cent loan to value now own only the debt and may be forced to take the company to market.

But despite the reduction in leverage, mitigation of balance sheet concerns, attractive valuations and availability of
distressed assets, many investors remain wary of real estate investment trusts (REITs).

The listed property sector took a battering over the past 18 months as companies struggled to refinance amid the credit crunch and ultimately defaulted on their loans. Some pension funds, suffering the effects of the liquidity freeze, were forced to sell down their listed holdings to finance capital calls in less liquid parts of the portfolio.

A research paper from the European Public Real Estate Association, highlighted by MLC Implemented Consulting, concluded that the UK listed property market leads movements in the underlying direct property market by an
average of six months, with a high correlation of 0.72.

The study also revealed that unlisted property returns exhibit lower volatility not only because of ‘smoothing’ by valuers who carry out appraisals infrequently (generally annually, sometimes quarterly), but also because of the free and clear’ methodology which ignores the impact of credit markets on the gearing component.

During the crisis, unlisted property markets continued to levitate, arguably reflecting the valuation lag. Proponents of the unlisted sector argue that REITs have been deservedly punished for greedy forays into non-rental
activities and excessive gearing.

Ritson Ferguson, the Pennsylvania-based CEO and chief investment officer at ING Clarion Real Estate Securities, expects property values to fall by about 30 per cent and says that pricing is already fully reflected in the listed property markets.

“[Funds] can buy in at prices that already reflect the declines in commercial real estate values that are likely to occur peak-to-trough and they’re able to get involved at a time when I think you’re at that cusp in the market,” he says.

“Over the next 12 months you’re likely to get some interesting returns because I think the erosion in fundamentals will
begin to subside and maybe even turn positive by this time next year or certainly the end of 2010 and at that point prices will have already adjusted upwards.”

But a question mark remains over the extent to which gearing drove returns in the past, and to what extent it is needed to drive returns in the future.

Historically, property companies delivered average returns of 10 per cent per annum, so as we move back to a lower
leverage environment, will expected returns from listed property deteriorate?

To the contrary, Ferguson says the new market environment provides an opportunity for institutional investors to gain attractive returns driven from equity, rather than debt.

“[With global listed markets trading on [average] at 7.1 per cent [implied cap rate] you’ve now got an opportunity on an
unleveraged basis to own real estate at a north of 7 per cent yield,”
Ferguson says.

“Companies haven’t abandoned leverage altogether, but they’ve reduced leverage from more than 50 per cent to 40-45
per cent, and I think they’ll continue to do so, so you can take that gross unlevered and with now manageable and sustainable levels of debt you can still drive 10 per cent returns out of that portfolio to the equity side.

“That’s not necessarily going to be lower returns than historical averages. We’ve repriced in the new reality to give
more like normal historical returns, and in what should be comforting for investors, all in a model that’s going to use less leverage than was becoming the norm by late 2007.”

Ferguson says property management teams have learnt that they should be more careful about the employment of leverage, even if this means losing out on property transactions to private equity buyers.

“They weren’t using the 70 and 80 per cent leverage that was used by some private equity buyers, like when Blackstone
bought Equity Office Properties and used leverage on that order,”
Ferguson says.

“Even the most levered property companies in the US were probably still only operating at 55 per cent loan to values. This capital market constraint has [made management teams say] even if I’m losing a little extra earnings per share, if I’m exposing myself to an environment where I might be priced out of the market from future activity, I’d rather keep a more unlevered balance sheet and have less levered earnings per share but maybe enjoy a better continuing multiple on the earnings I have because I de-risk them.”


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