Crunching through the gears - ULI research highlights the impact of leverage on property fund performance
January 14, 2013
London (14 January 2013) New research published by the Urban Land Institute (ULI) highlights the significant negative impact which leverage has had on the performance of European property funds between 2001 and 2011. The findings, published in Have Property Funds Performed?, demonstrate that leverage is the key driver behind the overall under-performance of investment vehicles over the last decade, in some cases reducing returns by up to 13.2% per annum for a 60% leveraged opportunity fund.
The report reviewed the performance of 169 European property funds using INREV and Property Funds Research (PFR) standards of core, value-added and opportunity funds to distinguish between investment styles and risk profiles. The research evaluated the extent to which these funds’ returns were driven by out-performance through skillful fund and asset management (alpha) and how much was determined by property investment risk including leverage (beta).
The research highlighted that annual total returns of core funds, which typically have little or no gearing and invest in prime assets, closely tracked the underlying IPD market index until 2009. Since this time they have underperformed the wider market, probably due to the impact of capital flows into and out of open ended funds. Over the whole period, leverage has accounted for a 1.1% reduction in performance for every 10% of debt in a fund (where debt is expressed as a percentage of GAV).
The impact of leverage is even clearer amongst value-added funds, which typically have more than 40% but less than 60% gearing and aim to generate some of their returns through active asset management. These funds out-performed the market between 2001 and 2007, but significantly underperformed the market between 2008 and 2011. The research demonstrated that every 10% of leverage within a fund reduced annual returns by 2.0%. Furthermore, the research uncovered that managers on average had been able to add to fund performance at a property level through asset management (alpha) and that leverage was the source of all of the under-performance.
Opportunity fund returns were characteristic of an investment vehicle with a higher risk profile, typically using in excess of 60% gearing and operating on a deal-by-deal basis. In particular, in years of abnormal market returns (i.e. 2005/06 and 2008/09) the relative returns were significantly higher or lower respectively than in the core and value-added funds. The report calculates that gearing led to a reduction in returns of 2.2% per year for every 10% of debt in a fund, equivalent to 13.2% per annum for a 60% leveraged investment. On a risk-adjusted basis opportunity funds have on average neither added nor destroyed value at a property level, indicating that the significantly high-level of underperformance has been the result of leverage.
The report also found that the selection of the right fund manager was critical for investors. There were significant differences in the performance of funds not only from year to year, but also across managers within years.
Professor Andrew Baum, academic fellow of ULI Europe and one of the authors of the report, comments: “The performance of property funds over the past decade is a complex picture, with returns impacted upon by a range of factors, including fund vintage, style and structure. However, the asymmetric effect of leverage, horribly damaging in the downswing, has had a huge impact on investor returns and value that has been created by intelligent asset management has in many cases been destroyed by the way in which the fund has been financed.”
Joe Montgomery, chief executive of the ULI Europe comments: “There has been a significant increase in the number of global and pan-European property funds since the mid-1990s. However, until now there has been very limited research not only into overall performance but also into whether strong or weak returns were the result of the skills and the decisions of fund and asset managers or were created by property risk or leverage. We are grateful to Professor Andrew Baum and Property Funds Research for undertaking such an extensive analysis of the market which provides clarity and will help both fund managers and investors alike.”
Notes to Editors:
Have Property Funds Performed? Report
Published in October 2012, the Have Property Funds Performed? report analysed the performance of 169 property funds including 70 core funds, 38 value-added funds and 61 opportunity funds. The report reviewed the period 2001– 2011, effectively the longest period available for which sufficient funds have been in existence, which enabled the performance of different fund types to be studied in periods of both very high and very low returns.
The research was undertaken by:
Professor Andrew Baum is Professor of Land Management at the Henley Business School, University of Reading and Honorary Professor of Real Estate Investment at the University of Cambridge. He is Chairman of Property Funds Research
Nick Colley is a Senior Analyst at Property Funds Research.
Jane Fear is Managing Director of Property Funds Research.
ULI gratefully acknowledges the generous support made by APG, CPP Investment Board, AREA Property