Optimum LTVs for UK REITs throughout the cycle

Transcription

1 Optimum LTVs for UK REITs throughout the cycle Alex Moss Managing Director Consilia Capital June

2 The UK REIT sector Time to reassess optimum LTVs It is now five years since two key events occurred which have reshaped the UK listed real estate sector; firstly the introduction of REIT legislation in the UK (January 2007) and secondly the beginning of the Global Financial Crisis (July 2007). It is also now three years since the successful (but emergency) recapitalization of the leading UK listed companies, ensuring they didn t breach their banking covenants. Now is therefore a good time to reassess the UK REIT sector and the issue of leverage for the following reasons: i) Relative market equilibrium means UK REITs have the chance to manage their optimal LTV going forward. With values static there is no immediate threat of breaching covenants or immediate requirement for rescue funding (at a REIT level anyway, if not a European country level. We discuss later how capital value movements are a key driver in the change in LTVs. In these instances LTV movements can be outside the control of REIT management teams, whereas changes in absolute debt levels can be actively managed. Therefore now is the perfect time for UK REITs to assess and implement their preferred LTV strategy over the medium term. ii) Investor preferences have shifted towards lower volatility, income driven returns. Against the backdrop of continued low interest rates and increased volatility investor preferences have moved towards total returns with a high- income component. Therefore the investment function of companies such as Land Securities and British Land is now as much income as capital driven, thus requiring a reassessment of optimal levels of capital gearing at the corporate level. Whilst high levels of capital gearing were regarded as necessary to generate enhanced NAV returns the switch in emphasis towards income requires a reassessment of levels that would optimize shareholder returns. iii) The decline in available bank debt has, by default, required UK REITS to focus on alternative sources of capital, and operate at lower LTVs. Despite appealingly low interest rates and a positive carry relative to property yields high LTVs are no longer available from debt providers. Therefore UK REITs have already utilized alternative sources of capital such as listed bonds and convertibles, US private placements, mezzanine finance, Joint Ventures, and ordinary and preferred equity issuance. In the likely absence of freely available bank debt at higher LTVs (say 65% +) REITs will have to continue to utilize external capital from sources. This paper looks at the following issues: 1) Firstly, the most fundamental question - Do holders of UK property actually need a leveraged position over time to outperform? We look here

3 at the underlying asset level returns. The high- income component is extremely stable over time so would adding leverage help enhance capital returns to achieve outperformance? In looking at this we establish two levels of benchmark (one relative and one absolute) to see how much leverage would be required to match the benchmark on an annual basis. 2) Secondly, we look at whether UK REITS have managed their LTVs actively, or they have been determined by the movements in capital values. 3) Thirdly we look at the implications for LTVs going forward. 1) Does UK property require leverage to outperform? Clearly, the case for attaching leverage and therefore risk at the vehicle (in this case REIT) level will be dependent upon the cyclicality and relative performance of the underlying asset. The first point we need to address is to attribute the component parts of the long- term asset performance, in this case over the last 25 years. For this we use the IPD UK Monthly Index. As can be seen from the chart below which looks at rolling annual returns two factors are immediately apparent i) the relatively high and stable income component (throughout rapidly fluctuating interest and inflation rates and extremes in terms of availability of bank debt) and ii) the cyclical and volatile nature of capital returns. Figure 1 UK property12month rolling returns Source: IPD

4 Having established the stable income component the second point to establish is how total returns on property compares to both a relative (FTSE All Share) benchmark and an absolute (9% total return pa) benchmark. The chart below shows i) the total relative return of the IPD UK Monthly Index, i.e. the absolute Total Return less the total return of the FTSE All Share Index. What is interesting is the number of years that ungeared property has outperformed UK equities (14 years out of 25). One of the key elements to this being the high- income return previously identified. The key point here being that an ungeared real estate portfolio outperformed equities 50% of the time. Source: IPD/FTSE Having identified that the underling asset outperformed half the time the next stage is to identify in how many more years it would have been possible to outperform if the portfolio had been geared. We can calculate the level of gearing required on a year- by- year basis. However, for this to work requires the co- incidence of relative underperformance with positive capital growth in the real estate portfolio. This last point is particularly crucial as by definition gearing can only aid performance if values are rising. The table below shows that in addition to the twelve occasions ungeared real estate outperformed there were another six years when applying a loan to value ratio of between 39% (currently regarded as close to an optimal level, and 75% (which is a level several Finance Directors would dread seeing again!). Nonetheless, prima facie, it does appear from this evidence that selective leverage would increase the incidence of outperformance at the asset level.

5 Source: IPD/FTSE/Consilia Capital However, as a word of caution, one should note that leverage would have to be applied on an extremely flexible basis, as there is only one occasion where it would have been advantageous to be geared for two years in succession. Having seen the situation with a relative benchmark, lets see what happens with an absolute benchmark, to see if the results differ. Debates rage long and hard about appropriate rates for cost of capital. For simplicity we have selected a figure of 9% as a benchmark that is sufficiently high to be meaningful. This increases the number of years when an ungeared UK real estate portfolio would have outperformed from 14 out of 25 to 15 out of 25.

6 Source: IPD However when we apply the same methodology as before it is noticeable that there is only one year (2011) when gearing would have helped outperformance. In all the other years adding gearing would have not helped, as capital values were negative Source: IPD/FTSE/Consilia Capital In summary it would therefore appear, based purely on performance that an ungeared strategy would have yielded acceptable relative performance to both a relative (equity market) and an absolute benchmark. It would appear that this is

7 due primarily to the high- income component, and it would have been difficult to selectively add leverage on those occasions when direct property underperformed. The fundamental reason for this is that in the majority of cases the underperformance is caused by declining values, thus leverage would only exacerbate the situation. Having seen the ungeared performance at the asset level the next step is to look at gearing at the corporate level. 2) Do REITs actively manage their LTV ratios? Having determined that it is extremely difficult to consistently enhance performance by altering LTV ratios at the property or corporate level we must now answer the question as to whether companies have historically allowed LTV rates to be determined by capital changes broadly outside their control or they have been actively managed by management decisions regarding changes in the absolute level of debt. We would regard the following measures as examples of active LTV management: 1) Increasing debt (via drawdown) to repay equity investors (Unibail), 2) the issue of equity to maintain LTVs at manageable levels (Eurocommercial) 3) taking debt off the balance sheet via a JV (British Land sale of 50% of Broadgate ) 4) selling assets purely to reduce debt How therefore can we determine whether companies have actively or passively managed their LTVs? Using the EPRA LTV Monitor for and the IPD data we extrapolate what would have happened to LTVs purely because of market movements, and compare this to what the actual LTVs were. We describe the theoretical LTV as the implied LTV. We reset the LTV each year to the actual result.

8 Source: EPRA/Consilia Capital As can be seen from the chart above a clear pattern emerges for different stages of the cycle: 2004 to 2006 with values rising and debt freely available the UK listed sector made acquisitions and increased their LTVs by additional debt, despite the negative drag on the LTV of rising property values we start to see a reversal of this trend as significant disposals occur the decline in values ramps up LTVs to the extent that in 2009 emergency recapitalizations are required. This pushes actual LTVs lower than would have been implied by value changes because of the addition of further equity capital. Since 2009 the recovery in values initially reduced LTV ratios again although this process has now stalled. The conclusion of this is that while capital values have a significant impact, the LTVs of the UK listed sector are not merely driven by capital changes, and at different stages of the cycle they have been actively managed to an extent, both to increase and decrease the ratio. 3) The outlook for LTVs going forward It seems that there are now a number of factors which mean that LTVs for UK REITs will not only be lower than historically, but that management teams will have to engage in a higher level of active LTV management than previously. These factors include: 1) The lack of available debt 2) The lack of retained profits due to REIT dividend payout rules 3) Minimal capital growth projections 4) A desire from investors for secure cash (dividend) income rather than cyclical unrealized capital growth 5) A need for UK REITs to follow the example of US REITs and actively use equity capital markets to finance expansion if the sector is to remain significant in a global context.