A question we are increasingly being asked, by a range of international clients, is “Should I buy or lend in a given market?”
That this is such a common query reflects not just an increased recognition of the lateness of the cycle in many markets (and the strategic benefit of shifting from equity to debt as the likelihood of a cyclical downturn in values increases) but also the greater sophistication and breadth of mandate of many investors, who, with more diverse sources and strategies of capital to call upon, are not so strategically limited as perhaps was the case historically.
Providing a quantitative response to this question – one that goes beyond an “It depends”, in other words – has not been simple, in part because of a lack of data. Thankfully, with resources like our European Forecasting service and Debt Map, we are now in a position to be able to put some numbers in the gaps and produce something approaching a scientific answer.
For the largest office market in 20 European countries, we have created hurdle rates of return for ungeared equity investors and debt investors. For equity investors, this comprises the risk free rate plus a risk premium, which we have determined for each market. For debt investors the hurdle rate is calculated in the same way, except we adjust the risk premium on a sliding scale according to prevailing LTV. (For a 60% LTV we assign half the equity risk premium, adjusting this amount upwards as LTV rises, so that a 100% LTV loan would have 100% of the risk premium).
It is important to understand that the risk premia we assign to each market are our assumptions, and will not be appropriate for all investors, many of whom will have significantly different views dependent on current and historic exposure and experience – consequently, a degree of caution is advisable in interpreting and applying our findings.
The chart below compares the extent to which forecast debt and (ungeared) equity returns will exceed or fall short of hurdle rates of return over the next five years. Forecasts of equity performance are taken from our EMEA Forecasting Service. Forecasts of debt performance are sourced from the CBRE Debt Map.
A number of interesting conclusions and patterns emerge from this analysis. Firstly, a majority (12) of markets are forecast to out-perform at least one of their debt or equity hurdle rates, suggesting that investors with a flexible strategy have plenty of opportunity to choose from. And it must be remembered that the seven markets forecast to under-perform hurdle rates are by no means no-go areas; investment in debt or equity in these markets merely requires superior deal selection skills, since the market can’t be relied upon to do the heavy lifting. Or, of course, investors may have different risk premia (and therefore lower hurdle rates).
Secondly, it is not the case that – as is often supposed – markets that are good for equity are bad for debt, and vice versa. If this were true, then all of the data points would be in either the top left or bottom right quadrants; in fact, a majority (14) are not. This shows that it is perfectly possible for markets to be simultaneously attractive (and unattractive) for both equity and debt alike.
Thirdly, there are six markets that are forecast to deliver above hurdle rate returns for both equity and debt. These include the three largest markets – London, Paris and Frankfurt – as well as Copenhagen, Oslo and Vienna. While there are some common themes uniting these markets, such as low risk premia (as indicated by the size of the data point) and low prevailing senior debt LTV (as indicated by the shading of the data point), these are not universally the case. And while many of the eight markets forecast to under-perform both debt and equity hurdle rates have high risk premia and high prevailing senior debt LTV, again this is not always the case.
Equity and Debt Performance Versus Hurdle Rate, Prime Offices
This analysis gets us closer to scientifically answering the question posed to us by the multi-strategy investor. But as caveated above, our risk premia will not apply to all investors, and a market under-performing at the average level need not dissuade an investor from selectively identifying opportunities that will deliver against hurdle rates. And then of course there are the curve balls; if the client on the other end of the phone happens to be a Korean investor, currently enjoying a positive carry from currency hedging of over 150bps, then very suddenly all bets seem to be on.
Our analysis shows that there are still interesting areas to invest in across the market, despite the late cycle conditions we are currently experiencing. It is though vital that to capture all opportunities investors are as flexible as they can be in their approach and consider debt as an asset class worthy of attention, depending on the market context.
By Richard Dakin, Managing Director, EMEA, Capital Advisors & Dominc Smith, Head of Real Estate Debt Analytics, CBRE.