According to the Investment Decision Rule, under what circumstances is a market considered less attractive, regardless of potentially optimistic assumptions?

Setting Real Estate Return Hurdles: A Risk-Adjusted Framework

Real estate investment decisions necessitate a robust framework for evaluating potential returns in relation to inherent risks. A critical aspect of this process is the establishment of appropriate return hurdles, which serve as benchmarks against which investment opportunities are assessed. This chapter addresses the crucial need for a scientifically sound, risk-adjusted framework for setting these return hurdles in the context of real estate investments. It recognizes the limitations of solely relying on projected GDP growth or forward rates of return without a comprehensive understanding of the underlying risks.

Overview

This chapter introduces a practical and rigorous methodology for determining appropriate real estate return hurdles, accounting for various risk factors inherent in different markets and asset types. The framework utilizes publicly available data to quantify risk and translate it into a minimum acceptable return, thereby protecting investors from deploying capital in markets that appear attractive but do not adequately compensate for the risks involved.

The chapter will cover the following key concepts:

• Decomposition of Real Estate Return: Examining the components of real estate returns, including the risk-free rate and various risk premia.
• Quantifying Country Risk: Evaluating and integrating country-specific risks, such as economic and political instability, into the return hurdle calculation.
• Assessing Real Estate Specific Risks: Analyzing within-country real estate risks, including transparency, liquidity, business, depreciation, and income security risks.
• Developing a Risk-Adjusted Hurdle Rate: Constructing a comprehensive model that combines risk factors to generate a risk-adjusted hurdle rate for real estate investments in different markets.
• Comparing Hurdle Rates with Expected Returns: Demonstrating how to use the developed hurdle rates to evaluate the attractiveness of real estate investments by comparing them with expected returns.

Setting Real Estate Return Hurdles: A Risk-Adjusted Framework

Setting Real Estate Return Hurdles: A Risk-Adjusted Framework

Defining Hurdle Rates

• A hurdle rate represents the minimum acceptable rate of return (MARR) for a real estate investment, reflecting the risk associated with deploying capital in a specific market.
• Hurdle rates serve as a benchmark for evaluating the attractiveness of different real estate markets, allowing investors to compare potential returns while accounting for risk.
• The framework for setting hurdle rates should be based on publicly available data and should be regularly updated to reflect changes in market conditions.
• The aim is to protect investors from deploying capital in markets that appear attractive based on forecast returns or projected GDP growth rates but do not offer sufficient compensation for the risks involved.

The Risk-Return Equation in Real Estate

The fundamental principle is that real estate investments should offer higher returns than less risky assets, such as government bonds, due to the inherent uncertainties associated with cash flows derived from households and businesses.

• The Real Estate Target Return (RETR) can be described as:

  RETR = RFR + RP

  Where:

  • RETR = Real Estate Target Return
  • RFR = Risk-Free Rate
  • RP = Risk Premium

• For international real estate investments, the risk premium must account for both country-specific risk and within-country real estate-specific risks.

• The risk premium reflects an investment in a stabilized "investment-grade" real estate asset. Development projects require an additional risk component.

• The Expected Real Estate Return (REER) of a market can be expressed as:

  REER = y + i + g

  Where:

  • REER = Expected Real Estate Return
  • y = Yield (current income return)
  • i = Expected Inflation Rate
  • g = Expected Rate of Real Rental Growth

• Investment Decision Rule: If RETR > REER, the market is considered investable, assuming unbiased forecasts. Conversely, if RETR < REER, the market is deemed less attractive, regardless of potentially optimistic assumptions about future rental levels or GDP growth.

Determining the Risk-Free Rate (RFR)

The risk-free rate is the theoretical return on an investment with zero risk.

• In practice, a truly risk-free investment does not exist.
• Traditionally, government bond yields (e.g., 10-year bond yields) have been used as a proxy for the risk-free rate, reflecting the illiquidity of real estate and aligning with the typical lifespan of a real estate fund.
• However, sovereign crises have cast doubt on the risk-free status of government bonds.
• A synthetic risk-free rate can be calculated as a GDP-weighted average of bond rates from high-credit-quality countries (e.g., Australia, Switzerland, Germany, Scandinavian countries, and the US).

Estimating a Fair Risk Premium (RP)

The real estate risk premium is defined as the income yield from the investment plus income growth minus the risk-free rate. In the long term income growth will generally rise with inflation.

• The risk premium should compensate investors for the risks associated with investing in a specific real estate market.
• Analysis of the City of London office market (1989-2011) suggests a long-term risk premium of approximately 3.8% (although this varies over time).
• The income from real estate is comparable to a bond coupon, with an additional equity component related to the value of the real estate itself when the lease expires.
• One approach to estimating the risk premium involves considering the credit quality of commercial real estate tenants. For example, if 25% of income is derived from "low-risk" tenants (AAA rating), 50% from "medium-risk" tenants (A rating), and 25% from "higher-risk" tenants (represented by an equity risk premium), the overall real estate risk premium can be calculated as a weighted average of bond and equity risk premiums.
• The equity risk premium (RPE) can be obtained by subtracting the average yield on the ten-year index-linked bond from the sum of the long-run average dividend yield on UK equity plus the long-run GDP growth rate of the economy.
• The components of the real estate risk premium on the fixed-income part are then calculated by subtracting the average yield on the index-linked gilt from the AAA and the A bond yield, respectively.
• Using these proportions and values delivers a risk premium of 3.7 percent. This number is higher than the risk premium on AAA corporate bonds, but is lower than risk premium on equities.
• It is reasonable to assume that this number is a fair representation of the risk premium of the City of London office market.

Components of the Risk Premium

The risk premium is composed of country risk and real estate risk.

Country Risk Premium

• Economic risk is lower in diversified economies with strong "automatic stabilizers," enforceable contracts, independent central banks, and world-class companies.
• Political risk includes major policy changes, regime changes, economic collapses, and war.
• The higher the country-specific risk, the greater the compensation investors will require.
• Country risk assessment methodologies, such as those produced by the New York University Stern School of Business (based on Moody's country credit ratings and bond spreads), can be used to quantify country risk.
• Risk premium values range from 0% in low-risk markets (e.g., Germany, Singapore) to 3.6% in emerging markets (e.g., India) to 10.5% in high-risk markets (e.g., Cuba).

Real Estate Risk Premium (Within-Country)

• Transparency Risk: Arises from scarce information and a lack of benchmarks. The Jones Lang LaSalle transparency index assesses the ability to measure market performance, availability of market information, presence of listed vehicles, respect for real estate rights, an efficient regulatory system, and the presence of qualified advisors/brokers. Premiums range from 25 bps to 125 bps.

• Liquidity Risk: Relates to the uncertainty associated with exiting an investment, both in terms of time and costs. Measured by comparing the size of average turnover in a specific market to the turnover of the global market and by calculating the share of transacted assets to the size of the investible stock. Premiums range from 50 bps to 150 bps for office markets and 75 bps to 175 bps for retail markets.

  • Relative Liquidity (RL) Calculation:
    RL = (Total Value of Transactions / Total Value of Investible Stock) * 100

• Business Risk: Refers to the uncertainty of a company's future cash flows, affected by the operations of the company and the environment in which it operates. Proxied by the standard deviation of notional long-run historic market rental growth. Premiums range from 55 bps to 125 bps.

• Depreciation Risk: Represents the loss in value of an asset over time due to wear and tear, physical deterioration, age, and locational obsolescence. Office sector carries a premium of 125 bps, while the retail sector carries 75 bps.
• Income-Security Risk: Based on typical lease lengths for the specific sector, rent guarantee period, and recovery of insurance costs from tenants. Proxied by data from DTZ. Values range between 25 bps and 1,500 bps.

Calculating the Unadjusted and Actual Risk Premium

1. Calculate the Unadjusted Risk Premium: Sum all risk components (country, liquidity, transparency, business, depreciation, and income security).

2. Scale to International Benchmark: Adjust the unadjusted risk premium relative to the risk premium for the City of London office market (defined as the international benchmark).

3. Calculate Target Return: Add the risk-free rate to the risk premium to determine the target return.

   Target Return = Risk-Free Rate + Scaled Risk Premium

Target vs. Expected Returns

• Compare the hurdle rate (target return) with the expected return each year to determine if a market is investable.
• If the expected return is greater than the hurdle rate, the market is considered investable.
• This provides a framework for making informed investment decisions based on a risk-adjusted analysis of potential returns.

Summary

This chapter focuses on establishing a risk-adjusted framework for setting real estate return hurdles, addressing the need for capital deployment in markets where returns justify the associated risks. It proposes a method for measuring risk and determining minimum acceptable return levels based on market characteristics.

• The framework aims to protect investors from deploying capital in markets that appear attractive based solely on forward rates of return or projected GDP growth, without adequately compensating for the risks involved.
• The real estate target return (RETR) is defined as the sum of the risk-free rate (RFR) and the risk premium (RP): RETR = RFR + RP. The risk premium compensates for both country risk and within-country real estate risk.
• The risk-free rate is calculated using a GDP-weighted average of bond rates from high-credit-quality countries (Australia, Switzerland, Germany, Scandinavia, and the US). The use of a synthetic risk free rate comes about because the status of government bonds as risk-free assets has come into question.
• The risk premium is comprised of country risk (economic and political stability) and real estate risk (transparency, liquidity, business, depreciation, and income security). Country risk is measured using a methodology based on Moody's credit ratings and bond spreads.
• The real estate risk premium is estimated based on an analysis of the City of London office market, considering the proportion of income derived from different tenant credit ratings (low, medium, and high risk). Data from IPD is used to assess tenant credit quality, and the premium is composed of roughly 75% bonds and 25% equity.
• The hurdle rate is compared with the expected real estate market return (REER), which is based on yield (y), expected inflation (i), and expected real rental growth (g): REER = y + i + g. A market is considered investible if RETR > REER.
• The framework provides a standardized measure of risk, allowing for ranking of markets based on risk-adjusted returns and enhancing portfolio diversification by including markets with potentially low but secure returns, augmented with gearing.