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Hurdle Rates For Real Estate

Investment

Theory and Practice

RICHARD BARKHAM

September 2009

Page 2

Page 4

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

Page 5

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.

Page 6

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.

Page 7

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

Page 8

SPECIFIC RISK FACTORS

■ Depreciation

– Technical

– Functional

– Locational

■ Supply / competition

■ Tax / legislative change

■ Ground conditions (for developments)

■ Construction cost overshoot (for developments)

Page 9

Page 10

THE VOLATILITY APPROACH

Page 10

Page 11

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

Page 12

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

Page 13

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

Page 14

THE RISK AUDIT APPROACH

Page 14

Page 15

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

Page 16

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

Page 17

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

Page 18

THE MARKET STRUCTURE APPROACH

Page 18

Page 19

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

Page 20

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

Page 21

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

Page 22

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

Page 23

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

Page 24

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

Page 25

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

Page 26

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