Real Estate Risk Premium: Yield Construction and Analysis

Chapter 5: Real Estate Risk Premium: Yield Construction and Analysis

5.1 Introduction

This chapter delves into the concept of the real estate risk premium, a critical component in determining the appropriate yield and, consequently, the value of a property investment. We will explore the theoretical underpinnings of the risk premium, methods for its construction, and the factors that influence its magnitude. Understanding the risk premium allows investors to more accurately assess the potential return relative to the inherent risks in real estate investments.

5.2 Defining the Real Estate Risk Premium

The real estate risk premium represents the incremental return an investor requires to compensate for the risks associated with investing in real estate compared to a risk-free asset❓. It is the difference between the expected return on a real estate investment and the return on a risk-free investment, such as government bonds❓.

Mathematically:

RPr = E(Rr) - Rf

Where:

• RPr = Real Estate Risk Premium
• E(Rr) = Expected Return on Real Estate
• Rf = Risk-Free Rate

5.3 The Risk-Free Rate as a Benchmark

The risk-free rate serves as the foundation for calculating the risk premium. It represents the theoretical return on an investment with zero risk of default. In practice, government bonds (e.g., UK Gilts, US Treasury bonds) are often used as proxies for the risk-free rate, as the probability of a government defaulting on its debt is considered very low. However, it’s important to acknowledge that even government bonds carry some degree of risk, such as inflation risk and interest rate risk.

5.3.1 Considerations for Choosing a Risk-Free Rate

• Maturity Matching: The maturity of the risk-free rate should ideally match the expected holding period of the real estate investment. For instance, if an investor plans to hold a property for 10 years, a 10-year government bond yield would be more appropriate than a 1-year yield.
• Currency Matching: The risk-free rate should be denominated in the same currency as the real estate investment.
• Zero-Coupon Bonds (Strips): Zero-coupon bonds, also known as strips (Separately Traded and Registered Interest and Principal Securities), represent the purest form of risk-free investment because they eliminate reinvestment risk. However, liquidity in strips markets can be limited, making it difficult to accurately determine spot rates.

5.4 Components of the Real Estate Risk Premium

The real estate risk premium is not a monolithic entity but rather a composite of various risk factors specific to real estate investments. These factors contribute to the overall risk and necessitate a higher required return. The primary components include:

1. Property Management Costs:

   • Real estate is a management-intensive asset. Ongoing costs such as property management fees, rent collection, rent review expenses, and lease renewal commissions reduce the net income stream.
   • To account for this, property management costs are deducted from the gross income yield to arrive at a net income yield.

   • Example:

     • Gross Income Yield: 7.00%
     • Basic Management (1% of rent): 1.00%
     • Rent Review Fees (5% of ERV every 5th year): (5% / 5 years) = 1.00%
     • Total Management Costs: 2.00%
     • Income Yield Net of Management Costs: 7.00% - 2.00% = 5.00%
       2. Tenant Renewing Lease Risk Premium:

   • This premium reflects the risk that a tenant may not renew their lease or exercise a break option, leading to a period of vacancy and lost income.

   • The premium is calculated by estimating the potential costs associated with tenant turnover, including void periods, re-letting fees, and potential capital expenditures to attract new tenants.

   • Example:

     • Net Income Yield: 6.895%
     • Tenant Renewal Fees (7.5% of ERV): 7.5% * 50% (probability) = 3.75%
     • Loss of Income (after mgt costs): 100% *50% (probability) =50%
     • Repairs and insurance (12% ERV): 12% * 50% (probability) = 6%
     • Void Rates(20% ERV after 3 months): 15% * 50% (probability) = 7.5%
     • Reletting Fees (15% ERV): 15% * 50% (probability) = 7.5%
     • Total Costs: 74.75% (divided by 10 to get annual premium= 7.475%)
     • Total Deduction From Income Yield: 0.515%
     • Income Yield Net of Probable Renewal Costs: 6.380%
       3. Tenant Default Risk Premium:

   • This component addresses the risk that a tenant may default on their rental obligations due to financial distress or business failure.

   • The premium is calculated by estimating the probability of default and the associated costs, including lost rent, legal fees, and re-letting expenses.
   • Default rates on corporate bonds can be used as a benchmark, although adjustments may be necessary to reflect the specific characteristics of real estate.

   • Example:

     • Net Income Yield: 6.380%
     • Loss of Income (after mgt costs): 100% * 2% (probability) =2%
     • Repairs and insurance (12% ERV): 12% * 2% (probability) = 0.24%
     • Void Rates(20% ERV after 3 months): 15% * 2% (probability) = 0.3%
     • Reletting Fees (15% ERV): 15% * 2% (probability) = 0.3%
     • Total Costs: 2.84%
     • Total Deduction From Income Yield: 0.181%
     • Income Yield Net of Probable Default Costs: 6.198%
       4. Allowance for Quarterly in Advance Cash Flow:

   • Commercial property rents are typically received quarterly in advance, whereas gilt coupons are paid half-yearly in arrears. This difference in cash flow timing can impact the present value of the investment.

   • The risk premium may be adjusted to reflect the benefit of receiving cash flows earlier. This can be calculated by comparing the Internal Rate of Return (IRR) of a quarterly in-advance income stream with a half-yearly in-arrears income stream.

   • Example:

     • Net Income Yield: 6.198%
     • Quarterly in Advance IRR: 6.446%
     • Half-Yearly in Arrears IRR: 6.294%
     • Total Addition to Income Yield: 0.152%
     • Income Yield Net of Income Pattern Adjustment: 6.350%

2. Illiquidity Premium:

   • Real estate is less liquid than other asset classes, such as stocks and bonds. It takes time to find a buyer, negotiate a sale, and complete the transaction.
   • The illiquidity premium compensates investors for the uncertainty of how long it will take to convert the investment into cash and the price they will receive.
   • A bridging loan❓ is a practical, although potentially costly, way to provide near instant liquidity.

   • Example:

     • Net Income Yield: 6.350%
     • 3-Month LIBOR: 5.000%
     • Margin over LIBOR: 3.000%
     • Total Interest Rate: 8.000%
     • Over Three Months: 2.000%
     • Loan Security Valuation (0.1% of capital value): 0.100%
     • Loan Arrangement Fees (0.1% of capital value): 0.100%
     • Total Costs: 2.200%
     • Annual Premium: 0.440% (total costs divided by 5-year holding period)
     • Net Income Yield after Illiquidity Premium: 5.910%

3. Transaction Costs:

   • Real estate transactions involve❓ significant costs, including stamp duty, legal fees, and agent commissions. These costs reduce the net return on the investment.
   • The risk premium is adjusted to reflect the impact of these transaction costs, typically amortized over the expected holding period.

   • Example:

     • Net Income Yield: 5.910%
     • Stamp Duty: 4.000%
     • Purchase Legal Fees: 0.500%
     • Purchase Agent’s Fees: 1.000%
     • Sales Legal Fees: 0.500%
     • Sales Agent’s Fees: 1.000%
     • Total Costs: 7.000%
     • Annual Premium: 1.400% (total costs divided by 5-year holding period)
     • Net Income Yield after Transaction Cost Adjustments: 4.510%

5.5 Calculating the Total Required Return

The total required return is the sum of the risk-free rate and the real estate risk premium. It represents the minimum return an investor expects to receive from the property investment to compensate for all associated risks.

Required Return = Risk-Free Rate + Real Estate Risk Premium

Example Summary:

• 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%

5.6 Practical Applications and Analysis

The constructed required return is then compared to the expected return on the property. If the expected return exceeds the required return, the property may be considered a good investment. The expected return is derived from the property’s equivalent yield, anticipated rental growth, and potential for yield compression (inward yield shift).

5.7 Limitations of the Build-Up Approach

While intuitive, the build-up approach has several limitations:

• Averaging Costs: Costs are averaged over the holding period, which may not accurately reflect the impact of short-term events, such as lease expiries.
• Rental Growth Risk: Investors are exposed to the risk that rental growth may not materialize as expected, particularly over longer periods.
• Other Risks: The model may not adequately capture all relevant risks, such as taxation, legal risks, sector-specific risks, and planning risks.
• Subjectivity: Estimating probabilities for events like tenant renewal can be highly subjective.

5.8 Alternative Approaches: Equity Analyst Perspective

Equity analysts use different metrics to calculate the risk premium. For example, comparing the IPD (Investment Property Databank) equivalent yield with an equity analyst’s approach helps to identify how to deconstruct the yield into different components.

Example
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

5.9 Risk-Adjusted Discount Rate (RADR)

A common valuation technique is the use of a Risk-Adjusted Discount Rate (RADR) in discounted cash flow (DCF) analysis. RADR is relatively easy and intuitive. However, using the RADR has limitations: (1) it is applied to all net cash flows, thereby failing to distinguish those elements for which the cash flows are fairly certain and those that are far more risky; (2) high discount rates penalize longer-term cash flows.

5.10 Conclusion

The real estate risk premium is a crucial concept for evaluating property investments. By carefully considering the various risk factors and constructing an appropriate risk premium, investors can make more informed decisions and achieve their desired returns.