FEP May Property Investment Research: an Agenda

Transcription

1 FEP May 2005 Property Investment Research: an Agenda

2 The Fisher equation Total required return comprises three parts where R = l + i + RP l is a reward for liquidity preference i is expected inflation RP is the risk premium

3 Fisher equation and gilt yields R = l + i + RP l is from required return on index-linked bonds: say 2% l + i is from required return on conventional government bonds: say 4.5% These are real and nominal risk free rates (RF R and RF N ), and RF N = RF R + i Fisher equation can be written as: R = RF N + RP

4 Risk free rates/expected inflation Yield on conventional bonds - yield on index-linked government bonds = expected rate of inflation (2.5%) But are fixed interest government bonds risk free? For pension funds, liabilities are real and fixed interest investments are risky Then 4.5% = 2% + i + RP Say 4.5% = 2%+ 2% + 0.5% Inflation expectations are then 2%, not 2.5%

5 Gordon s growth model Assume constant rate of growth in nominal income (G) Then: k = R - G where k is an initial yield R is the required return G (nominal) = g (real) + i (inflation)

6 Gordon s growth model Assume 2.5% real growth in dividends (GDP) Nominal growth: G = g + i = 2.5% + 2% = 4.5% For a Land Secs share: assume RP = 3% The correct yield is given by: k = R - G = 4.5% + 3% - 4.5% = 3.0%

7 Depreciation and property Rental growth is usually measured for hypothetical properties Forecasts are estimated in the same way what will best office rents be in Paris in 2003? what is the rate of growth for best buildings? Real buildings wear out refurbishment expenditure rents decline relative to new cap rates rise relative to new

8 A property valuation model Assume: constant rate of depreciation (d) = 2% RP for office property = 3% G = long term average of 4% nominal (1% real) Then: k = RF N + RP - G + d k = 4.5% + 3% - 4% + 2% = 5.5% The correct yield is 5.5% If the current yield is 7%: offices are cheap

9 A property valuation model K = RF N + RP - G N + D where K = cap rate RF N = nominal risk free rate RP = risk premium G = nominal rental growth D = depreciation

10 A property valuation model K = RF N + RP - G N + D Limitations: Holding period return? Cap rate movement is it auto-correlated? Lease effects?

11 Components of capital return Capital return Cap rate movement Lease effect Rental growth 15.83% 4.63% 1.70% 8.51%

12 K = cap rate Gross or net? Gross yield: the ratio of gross income (income before nonrecoverable cost are allowed for) over net purchase price (net purchase price excluding other costs associated with the transaction). Net yield: the ratio of net income (income after allowing for non-recoverable costs of ownership) over gross purchase price (purchase price plus other costs of acquisition).

13 K = cap rate Effect of lease terms and incentives?

14 Cash flow: short lease with break Rent ( ) Year no break with break

15 RF N = nominal risk free rate What duration bond? Government, corporate? Default risk, liquidity? Yield curve and spot rates?

16 RP = risk premium Measuring risk v accounting for risk CAPM, WACC? Simulation?

17 Scenario-generated premiums IRRs (%) IRR SD (%) RP (%)

18 G N = nominal rental growth West End Offices Dependent Variable: O_WENDEQYL Method: Least Squares Date: 04/04/05 Time: 15:35 Sample(adjusted): Included observations: 17 after adjusting endpoints Variable Coefficient Std. Error t-statistic Prob. C O_WENDEQYL(-1) *DLOG(O_WENDXERVGR) SWAP5_MIDYEAR(-1)

19 D = depreciation It affects property investment performance It is a key (yet poorly understood) input into property investment decision-making It has an influence on tax, accounting and distribution rules for property companies and REITs It has an impact on the efficiency of contractual arrangements between landlord and tenant

20 Theory Depreciation Obsolescence Deterioration Configuraion Exterior Interior Exterior Interior

21 Rental decline by age-band Index,0-4 years= Age-band (Years) London Single-let London Multi-let Paris Frankfurt Amsterdam Stockholm

22 Results 20 year sample Sample size DEPR RATE Shops % Office % Industrial % All Prop % Reading/IPD, 2005