A Borrower Not A Lender Be

Why the most rewarding way to get exposure to UK property is via debt.

In our new Debt Analytics MarketView, we examine the returns available from senior lending to UK commercial real estate, and give a full explanation of the impact of changes in the market over the last three months – swaps up, margins down, default risk rising as capital growth forecasts decline. We also compare the returns forecast to be earned by lenders to those of investors. Given the current outlook, it seems that investors who have the option (which will not be everyone) might do better as lenders rather than borrowers.

Figure 1 compares returns from debt and equity exposure to UK property over the last 25 years. The debt returns series is our own, based on our proprietary default and loss model (about more of which here), and shows returns by year of origination assuming a five year loan to a broad portfolio of UK commercial property at a 65% LTV. The equity returns series is the MSCI all property total return, on a rolling five year basis (to be comparable with the debt series).

Figure 1 Comparison of debt and ungeared equity returns

Over the long term, as would be expected, equity exposure has delivered a higher return than debt exposure by a margin of around 2% per annum. With regards the current situation, forecast returns for the five years from Q2 2017 are 3.0% for debt and 4.4% per annum for equity. The margin of forecast out-performance is thus below the long-term average.

Historic out-performance has been at the expense of higher volatility (again, as expected), and the margin of out-performance has varied from +8% to -4%. While debt has only out-performed equity in five periods, these periods coincided with the top of the cycle – the UK property market peaked in 2007, and the 2003-2008 period is the first of five periods of out-performance by debt.

In other words, at the top of the cycle, with downside risk heightened, investors benefit from the downside protection offered by debt.
Tactically and strategically then, there are compelling arguments for reallocating towards debt: returns on equity offer less of a premium than has historically been available, and as the cycle matures it makes sense from a risk perspective.

This latter point can also be seen in Figure 2, which compares the Sharpe ratio of debt and equity at the all property and segment levels. The Sharpe ratio expresses excess return (over Gilts) relative to the volatility of that return, and can be thought of as showing a risk-adjusted outlook. The Sharpe ratio for debt, at 1.0%, is considerably above that for equity, at 0.8%, while debt also out-performs in five out of seven segments.

Figure 2: Sharpe ratio of debt and equity investment, Q2 2017-22

Far from “oft losing”, lending would seem to be the current preferred friend of the multi-asset real estate investor.

By Dominic Smith, Head of Real Estate Debt Analytics, UK,  CBRE