Real Estate Risk Premium: Yield Construction

Chapter Title: Real Estate risk❓ Premium: Yield Construction

Introduction

This chapter delves into the construction of real estate yields by meticulously examining the various components that contribute to the required return for a property investment. A central concept is the real estate risk premium, the additional return investors demand for investing in real estate compared to risk-free assets❓. We will explore how to build a required return by quantifying elements of market and specific risk and integrating them into the yield analysis.

5.6 Property Yields Relative to Gilts Yields: The Risk Premium Calculation

This section explores the relationship between gilt yields (government bonds) and property yields. The goal is to build a required return for a subject property, reflecting elements of market risk, property-specific risk, and simple methods for pricing these risks. For illustration, we’ll assume a rack-rented property with a current income yield of 7%.

5.6.1 Risk-Free Rate

The risk-free rate is the theoretical rate of return on an investment with zero risk. In practice, this is approximated by the yield on government bonds, such as UK Gilts, under the assumption that the government is highly unlikely to default. The property risk premium is added to this risk-free rate to arrive at the required return on a property investment.

• Theoretical Basis: The risk-free rate forms the foundation of asset pricing models. The Capital Asset Pricing Model (CAPM), for example, uses the risk-free rate as a starting point to determine the required rate of return on an asset based on its systematic risk (beta).

  • CAPM Formula: E(Ri) = Rf + βi [E(Rm) – Rf]

    Where:
    * E(Ri) = Expected return on asset i
    * Rf = Risk-free rate
    * βi = Beta of asset i (a measure of systematic risk)
    * E(Rm) = Expected return on the market portfolio

5.6.2 Property Risk Premium

The property risk premium is the incremental return demanded by investors for investing in real estate instead of a risk-free asset. It represents compensation for the various risks inherent in property investments.

• Historical Perspective: Traditionally, a 2% risk premium was commonly used, based on the historical relationship between prime property yields and gilt yields before the reverse yield gap (when property yields fall below gilt yields). However, this historical differential may underestimate the current required risk premium, as investors have become more aware of property’s shortcomings compared to other asset classes.

• Components of the Risk Premium: The property risk premium is composed of several factors, including:

  • Property Management Costs
  • Tenant Renewing Lease Risk
  • Tenant Default Risk
  • Cash Flow Timing
  • Illiquidity Premium
  • Transaction Costs

We will analyze and estimate each component individually.

1. Property Management Costs

Real estate is management-intensive, requiring ongoing costs for rent collection, rent reviews, and lease renewals to maintain income generation.

• Example: Based on a single-tenant property on a ten-year lease (Table 5.2 from the provided text), we assume management expenses average 1.5% of the rent per annum. This is deducted from the gross income yield.

  • Net Operating Income (NOI) Calculation:

    • NOI = Gross Rental Income – Operating Expenses
    • Where Operating Expenses include:
      • Property Management Fees
      • Rent Review Fees (e.g. 5% of Estimated Rental Value (ERV) every 5 years, amortized)
      • Maintenance
      • Insurance

  • Mathematical Formulation (Simplified):

    • Net Income Yield = Gross Income Yield * (1 – Management Expense Ratio)
    • Where Management Expense Ratio = (Total Management Expenses / Gross Rental Income)

  • Example:

    • Gross Income Yield = 7.000%
    • Basic Management (% rent) annually = 1.000%
    • Rent review fees (% ERV) every other 5th anniversary = 5.000%
    • Total as % Income = 1.500%
    • Total deduction from income yield (7.000% × (1−1.500%) = 0.105%
    • Income yield net of management costs = 6.895%

2. Tenant Renewing Lease Risk Premium

This risk stems from the possibility that a tenant may not renew their lease or may exercise a break option, disrupting the income stream. This acknowledges the greater volatility of property income compared to bond income.

• Quantification: A probable annual cost is calculated and deducted from the income yield (Table 5.3 from the provided text). This cost is based on the possibility of a void period (e.g., 12 months), including lost rental income, maintenance, insurance, void rates, and re-letting costs.

• Probability Weighting: Since not all tenants will vacate, the example assumes a 50% chance of renewal. Renewal fees and re-letting costs are spread over the ten-year lease term.

  • Formula:

    • Annual Lease Renewal Premium = (Probability of Non-Renewal * Total Costs of Non-Renewal) / Lease Term
    • Total Costs of Non-Renewal = Void costs❓❓ + Reletting Costs + Tenant Renewal Fees
    • Void Costs = (Lost Rent * Void Period) + (Operating Expenses * Void Period)

3. Tenant Default Risk Premium

This represents the risk that a tenant will fail to pay rent due to business failure or other reasons. The pricing is similar to the renewing lease risk premium, encompassing the cost of vacancy, re-letting, and lost rent.

• Guidance from Ratings Agencies: Default ratings from agencies on corporate bonds can provide some guidance, although property has a re-letting recovery rate unlike bonds.

• Default Rate Assumption: A default rate is assumed (e.g., 2% per annum for the grade of tenant, based on long-term averages, Table 5.4 from the provided text).

  • Formula:

    • Annual Default Risk Premium = Probability of Default * (Lost Rent + Re-letting Expenses + Void Costs)

4. Allowance for Quarterly in Advance Cash Flow

Commercial property rents are usually received quarterly in advance, whereas gilt coupons are paid half-yearly in arrears.

• Adjustment: A quarterly in advance cash flow is more valuable than a half-yearly in arrears flow. A reduction in the risk premium is made to reflect this benefit (Table 5.5 from the provided text).
• Calculation Methods:
  • Compare the Internal Rate of Return (IRR) from a quarterly in advance income stream with a half-yearly in arrears stream using a spreadsheet.
  • Calculate effective capitalization rates using quarterly in advance and bi-annually in arrears conversion formulas.

5. Illiquidity Premium

Real estate is less liquid than assets like bonds or equities. Investors demand a premium for the uncertainty surrounding the time it takes to convert the investment to cash and the potential sale price.

• Bridging Loan Analogy: The price of achieving the same liquidity as securities can be estimated by considering a bridging loan equal to the sales proceeds. Assume three months from the decision to market a property until completion (Table 5.6 from the provided text). Market terms can be used for the margins above LIBOR for 100% bridging loans and their arrangement costs.

• Hedging with Options (Theoretical): A theoretical approach to valuing the upside/downside potential during sale can be found with a “collar strategy” of a long put and a short call.

  • Formula (Approximation):

    • Illiquidity Premium = (Cost of Liquidity Provision) / Holding Period
    • Cost of Liquidity Provision ≈ Bridging Loan Interest + Loan Arrangement Fees + Valuation Fees – Rental Income During Sale Period

6. Transaction Costs

The transfer costs for property are significantly higher than those for bonds. Stamp duty, conveyancing fees, and agents’ fees on sale and purchase should be reflected in the required rate of return.

• Amortization: Assume “round tripping” costs of 7% every five years and amortize them over the holding period (Table 5.7 from the provided text).

  • Formula:

    • Annual Transaction Cost Premium = (Total Transaction Costs) / Holding Period

Total Risk Premium

Adding up all the above components gives the total required return (Table 5.8 from the provided text).

• Rule of Thumb: The property risk premium is typically around 2% for institutional-quality property. However, this figure varies depending on tax and market conditions.

Decision Making

The buy/sell/hold decision depends on whether the expected return from the asset exceeds the required return. If the equivalent yield plus expected rental growth and/or an inward yield shift exceeds the required return, the property may be a buy or continued hold.

Drawbacks of this Approach

While intuitive, this required return construction method has some drawbacks:

• Averaging Costs: Averaging costs does not account for events in the short term, like lease expiries.
• Rental Growth Risk: There is a risk that the expected reversion will fall from today’s values. The longer the period to the next review or lease expiry, the greater the required rental growth risk premium.
• Other Risks: Other risks such as taxation, legal risks, sector risks, and planning risks exist.
• Garbage in, garbage out: Simulation models can help analyze these factors. They require judgment inputs and can be vulnerable to the ‘garbage in – garbage out’ trap.

5.7 Property Equity Analysts’ Approach

The equity analysts’ approach can be compared to the built-up approach, including factors like depreciation and the impact of rent reviews, as presented in Table 5.9 of the file content.

5.8 Risk Adjusted Discount Rate

The risk adjusted discount rate (RADR) is a common tool for property analysts and investors in a discounted cash flow (DCF) analysis.

• Limitations:
  • One discount rate is applied to all net cash flows, so it fails to distinguish those elements that are more or less risky.
  • High discount rates penalize long-term cash flows and focus attention on short-term cash flows.
  • The rate can be excessively misleading in extreme circumstances if not well understood the timing of risk.

Conclusion

Constructing real estate yields and determining the appropriate risk premium is a crucial aspect of real estate valuation and investment decision-making. By carefully considering all the factors described above, investors can make more informed assessments of the risks and potential returns associated with real estate investments.