Leverage, risk and appraisal methodology in commercial property investment: it’s the way we teach them
||Leverage, risk and appraisal methodology in commercial property investment: it’s the way we teach them
||21st Annual European Real Estate Society Conference in Bucharest, Romania
||Recent research (notably Fuerst et al, Drivers of Fund Performance, INREV 2013) has revealed the negative impacts of leverage on returns to investors in commercial real estate over the last decade. As usual in post-crash inquests, it is most common to blame bank lenders for “rash” lending in booms, followed by investors or managers for “rash” borrowing. This paper argues that some of the blame also lies with the appraisal methods applied to leveraged investments, and therefore ultimately with the way those methods are taught. A schematic valuation model, based on standard WACC and DCF calculations, is used to investigate the often misunderstood factors – inter alia the relative pricing of real estate and debt, relationships between asset returns and interest rates, asset income growth, tax regimes - which determine the risk adjusted returns on leveraged compared to unleveraged investments. The model is used to illuminate the critical conditions necessary to produce risk-adjusted return - or even absolute returns - on leverage investment superior to unleveraged investment. It is suggested that the prospectuses for leveraged real estate funds presented to investors should include quantified risk statements showing these critical conditions, plus the probability distributions of likely outcomes. In addition, the paper reviews the treatment of leveraged risk in the most widely used appraisal textbook, and (via an informal survey) the appraisal models applied by leading fund managers. In both cases, it is argued that a lack of explicit treatment of risk and risk adjusted returns has contributed to the excess leverage of commercial real estate, and therefore that teachers of appraisal methodology need to go well beyond the current standard texts in their treatment of leverage and risk.
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||G: Market Research, Analysis & Forecasting
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