Real Estate Yield Construction: Risk Premium Analysis

Chapter: Real Estate Yield Construction: Risk Premium Analysis

Introduction

This chapter delves into the critical process of constructing real estate yields❓❓ by examining the risk premiums associated with property investments. Understanding risk premiums is fundamental for accurate property valuation and investment decision-making. We will explore the theoretical underpinnings of risk-free rates and how to build a comprehensive risk premium reflecting various factors specific to real estate.

1. The Foundation: Risk-Free Rate

1.1. Definition and Significance

The risk-free rate serves as the bedrock upon which all other risk premiums are added to arrive at a required rate of return for a real estate investment. It represents the theoretical return an investor would expect from an investment with zero risk.

1.2. Proxies for the Risk-Free Rate

In practice, a truly risk-free asset is impossible to find. Government bonds, particularly those issued by stable and creditworthy governments, are commonly used as proxies. For investments denominated in GBP, UK Gilts are typically considered.

1. 2. 1. Limitations of Using Government Bonds: While government bonds offer a low-risk profile, they are not entirely risk-free. Inflation risk, interest rate risk, and liquidity risk can still affect their returns.
2. 2. 2. Zero-Coupon Bonds: Zero-coupon bonds (“strips”) isolate the impact of reinvestment rate risk, because they provide a single payment at maturity. These bonds are more difficult to value accurately, due to low trading volumes (Adams et al., 2003).

1.3. Determining the Appropriate Maturity

The maturity of the government bond used as a proxy should ideally match the investment horizon of the real estate project. This minimizes the impact of interest rate risk.

2. Deconstructing the Property Risk Premium

2.1. Definition and Rationale

The property risk premium is the incremental return investors demand for investing in real estate compared to a risk-free asset. It compensates for the inherent risks associated with property ownership.
Historically, there has been an assumed risk premium of 2% between prime property yields and gilts yields prior to the reverse yield gap. However, more recently this has risen to almost 4% (as of this text). This change is largely due to an increase in awareness of the shortfalls of property investments such as lack of liquidity and increased transaction costs.

2.2. Key Components of the Property Risk Premium

The property risk premium is not a monolithic entity but a sum of individual risk factors. Below are key risks associated with property investment and their calculations:

1. Property Management Costs (PMC)

2. 1. Description: Real estate requires ongoing management, including rent collection, rent reviews, and lease renewals.

   2. Calculation: Express management costs as a percentage of gross income. This percentage is then multiplied by the gross income yield, and subtracted from it to determine the income yield net of management costs.

   3. Formula: Income Yield (Net of PMC) = Gross Income Yield * (1 – PMC%)

   4. Example: Given a gross income yield of 7% and basic management costs of 1%, plus rent review fees of 5% every 10 years (resulting in total costs of 1.5% of income), the net income yield is calculated as: 7% * (1 - 0.015) = 6.895%.

3. Tenant Renewing Lease Risk Premium (TRLRP)

4. 1. Description: The risk that a tenant may not renew the lease introduces income volatility.
   2. Calculation: Estimate the potential costs associated❓ with tenant turnover, including void periods (loss of income), repairs, insurance, and re-letting fees. Assign a probability to the tenant not renewing and calculate the expected annual cost. The risk premium can be calculated as the cost spread over the lease term.

   3. Formula:
      TRLRP = (Probability of Non-Renewal * (Loss of Income + Repairs + Insurance + Void Rates + Re-letting Fees)) / Lease Term

      If using Equivalent Rental Value (ERV):
      TRLRP = (Probability of Non-Renewal * ((Void Period Income Loss) + (Repairs + Insurance)ERV + (Void Rates)ERV + (Re-letting Fees)*ERV)) / Lease Term

   4. Example: Assuming a 50% chance of non-renewal, a 12-month void period, total costs equalling 74.75% of income and a 10-year lease, the cost is spread over 10 years to determine the premium. Loss of income from a void, repairs and insurance, void rates and reletting fees are each valued at a percentage of the ERV, resulting in a subtotal. This subtotal is multiplied by the probability of that outcome and the result is the tenant renewal lease risk premium.

5. Tenant Default Risk Premium (TDRP)

6. 1. Description: The risk that a tenant may default on rent payments.
   2. Calculation: Estimate the probability of default for tenants of a specific credit grade and the associated costs (void period, re-letting, loss of rent).

   3. Formula:
      TDRP = Probability of Default * (Loss of Income + Repairs + Insurance + Void Rates + Re-letting Fees)
      If using Equivalent Rental Value (ERV):
      TDRP = Probability of Default * ((Void Period Income Loss) + (Repairs + Insurance)ERV + (Void Rates)ERV + (Re-letting Fees)*ERV)

   4. Example: The property is vacated at a rate of 2% per annum, resulting in a loss of income, repairs and insurance, void rates and reletting fees which are all valued as a percentage of the ERV, which are all accounted for in the subtotal. The subtotal is then multiplied by the probability of that outcome, resulting in the tenant default risk premium.

7. Cash Flow Timing Adjustment (CFTA)

8. 1. Description: The timing of cash flows impacts their present value. Property rents are typically received quarterly in advance, while gilt coupons are paid semi-annually in arrears.

   2. Calculation: Determine the internal rate of return (IRR) for both a quarterly in advance and a semi-annually in arrears cash flow stream, assuming the same annual income. The difference in IRR reflects the added value of the more frequent, upfront cash flow.

   3. Formula: CFTA = IRR (Quarterly in Advance) - IRR (Semi-Annually in Arrears)

   4. Methods: Use a spreadsheet or specialized financial calculator.

   5. Effective capitalisation rates can be calculated using quarterly in advance and biannually in arrears conversion formulae.

9. Illiquidity Premium (IP)

10. 1. Description: Real estate is less liquid than other assets like bonds or equities. It takes time and effort to convert a property into cash.
    2. Calculation: Estimate the time required to sell the property (e.g., three months). Calculate the cost of bridging finance (short-term loan) to cover the period until the sale completes. This involves sourcing market interest rates for bridging loans and factoring in associated arrangement fees (valuations, etc.). Amortize the costs over the expected holding period.

    3. Formula:
       IP = (Bridging Loan Interest + Loan Arrangement Costs) / Holding Period

    4. Example: Margin over LIBOR is 3%, interest rate is 8% with three months to completion. This makes the total interest cost 2% over three months. Then factor in costs of valuation, and arrangement fees to determine costs, which is then divided by the number of years in the holding period to get the annual premium.

    5. Transaction Costs (TC)
    6. 1. Description: Real estate transactions involve significant costs such as stamp duty, conveyancing fees, and agent fees.
    7. Calculation: Estimate the total transaction costs (“round tripping”) as a percentage of the property value. Amortize these costs over the expected holding period.
    8. Formula: TC = Total Transaction Costs / Holding Period
    9. Example: Considering stamp duty, purchase legal fees, purchase agent fees, sales legal fees and sales agent fees, the total costs are divided by the holding period to determine the annual premium.

2.3. Formula for Risk Premium

The total risk premium (RP) can be calculated by summing up all the above components:

RP = PMC + TRLRP + TDRP + CFTA + IP + TC

3. Practical Application and Examples

3.1. Yield Construction Example

Risk-free Rate: 3.000%

Expected Inflation: 2.500%

Property Management Costs: 0.105%

Tenant Renewing Lease Risk Premium: 0.515%

Tenant Default Risk Premium: 0.181%

Quarterly in Advance Adjustment: -0.152%

Illiquidity Premium: 0.440%

Transaction Costs: 1.400%

Total: 7.990%

4. Limitations and Considerations

4.1. Averaging Costs: The above method averages costs over the holding period, potentially understating the impact of short-term risks (e.g., near-term lease expiries).

4.2. Rental Growth Risk: The risk that expected rental growth may not materialize, especially over longer periods.

4.3. Other Risks: Factors such as taxation, legal changes, and planning regulations can influence returns and should be considered.

5. Advanced Modeling Techniques

5.1. Simulation Models: Software like @Risk and Crystal Ball can incorporate probabilities and ranges for various risk factors to generate a distribution of potential returns. These can be useful for indicating shifts in certain factors, but may be too complex given the number of inputs required.

5.2. Scenario Analysis: Examine how different combinations of risk factors (e.g., high tenant default rate coupled with a prolonged void period) impact overall returns.

6. Alternative Method: Property Equity Analysts’ Approach

6.1 Equity Analysts’ approach is used to deconstruct the IPD equivalent yield and compare with the equity analyst’s approach

6.2. Example based on Schroder Saloman Smith Barney estimates:

Yield component % Comment

Risk-free real benchmark +2.4% Index-linked bonds with a 10 year maturity

Tenant risk premium +2.9% Moody’s Baa 10 year corporate bond spread

Depreciation +1.2% Building depreciation absorbed by the landlord

Transaction costs +0.8% Legal, agent and stamp duty amortised over 10 years

Management costs +1.0% Annual cost of outsourcing management costs

Rents payment profile −0.3% Advantage of quarterly in advance cash flows

Impact of rent reviews +0.3% Five yearly steps, rent monetised at review

Liquidity adjustment −0.1 Property – gilt returns over a one month transaction period

Void adjustment +0.5% Impact of tenant delinquencies and voids at lease expiries

Long term rental growth −0.0 Deduct real growth at portfolio level

SSSB implied equivalent yield 8.6% Theoretical yield basis (rounded)

IPD equivalent yield 8.4% Assumes quarterly in advance rents

Difference +0.2% SSSB relative to IPD

7. Risk-Adjusted Discount Rate (RADR)

7.1. Definition: Use of a risk adjusted discount rate in a discounted cash flow analysis to indicate if the user is heading in the right direction.

7.2. Limitations: Main limitations being applying one discount rate to all net cash flows, not distinguishing those eleme.

Conclusion

Constructing a real estate yield requires a thorough understanding of risk-free rates and the various components of the property risk premium. By carefully analyzing each risk factor and applying appropriate adjustments, investors can arrive at a more informed and accurate required rate of return, leading to better investment decisions. The approaches laid out above act as a guideline, and do not function as an exact science. There will need to be adjustments depending on the type of property, and the investor.