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Hurdle Rates For Real Estate
Investment
Theory and Practice
RICHARD BARKHAM
September 2009
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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
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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.
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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.
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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
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SPECIFIC RISK FACTORS
■ Depreciation
– Technical
– Functional
– Locational
■ Supply / competition
■ Tax / legislative change
■ Ground conditions (for developments)
■ Construction cost overshoot (for developments)
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THE VOLATILITY APPROACH
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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
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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
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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
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THE RISK AUDIT APPROACH
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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
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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
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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
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THE MARKET STRUCTURE APPROACH
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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
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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
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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
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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
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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
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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
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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
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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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