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Finding Value for Geared Investors

by | Mar 21, 2019

Where can investors use gearing to achieve stronger returns?

 

We have talked previously of the changes in pricing of debt over 2018. Here we examine the extent to which required capital growth has changed, and whether investors are likely to achieve required levels of performance according to our forecasts.

For major office markets in 20 countries across Europe we have estimated required return (by summing the risk free rate and a market-specific risk premium) and determined required capital growth by subtracting income return (yield). We have done this on a geared basis, assuming that an investor uses senior debt on terms identical to those quoted in our Debt Map. To this, we compare forecast capital growth to understand which markets are expected to over-deliver and which are expected to under-deliver against this threshold.

Figure 1 shows that investors should be able to achieve greater than required capital growth in a number of major markets – including Paris, Frankfurt and London – as well as some mid-tier markets – such as Brussels and Copenhagen. Performance should be broadly in line with that required in markets such as Vienna, Budapest, Milan, Amsterdam and Stockholm. In the remaining markets, required capital growth is higher than our forecasts, often as a result of challenging risk premia.

The changes in debt market pricing discussed in our previous article have an impact on the level of required capital growth: where debt terms ease (LTVs rise, margins fall), generally required capital growth would decline, and vice versa. Complimenting or countering this could also be changes in property yields (falling yields would raise required capital growth) or in the risk free rate (rising Government bond yields would increase required return).

Figure 2 shows how required capital growth for investors using senior debt changed over the course of 2018, breaking the total change down into component parts.

  • For the most part, the impact from interest rates and Government bonds was fairly benign in 2018. The notable outlier perhaps was Italy where rising Government bond yields added 2.3% (or about 0.5% per year) to required capital growth.
  • Yields declined in a majority of markets (11 out of the 20 below) in 2018, putting upwards pressure on required capital growth. This trend was most pronounced in the CEE markets but also in Italy and Netherlands, where required capital growth ended the year 3.6% and 2.5% higher respectively. By contrast, a slight rise in yields in Germany reduced required capital growth by 0.5% (about (0.1% per year).
  • Overall, ten markets saw easing debt terms reduce required capital growth, by as much as 4.9% (about 1% per year) and 7.4% (about 1.5% per year) in Ireland and Spain respectively. A few markets (six) saw required capital growth rise as a result of debt getting more expensive. In many cases, the impact on required return – whether positive or negative – from changing debt terms was counter-balanced by that from the consequent change to the risk premia multiplier – when LTV rises, so does the risk premium because of an upwards impact on volatility. This shows that in many cases the impact of debt pricing can be understated: far more important as a driver of risk-adjusted performance is the outlook for the underlying asset and market.
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