Leverage is the main reason why investment vehicles have been underperforming over the past decade, according to research published by the Urban Land Institute (ULI).
In some cases, returns were reduced by as much as to 13.2% per annum for a 60% leveraged opportunity fund, the ULI says.
“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 the 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,” says one of the authors of the report, Professor Andrew Baum, professor of land management at the Henley Business School and University of Reading and academic fellow of ULI Europe.
Performance profiles reviewed
Along with co-authors Nick Colley, senior analyst at Property Funds Research; and Jane Fear, managing director of Property Funds Research, Baum 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 investment styles and risk profiles.
The report, Have property funds performed? examined the extent to which skilful fund and asset management (alpha) property investment risk including leverage (beta), caused outperformance.
The context of the study is the significant growth in the aggregate size and number of global property funds that has occurred since the mid 1990s, fuelled largely by the investment of significant capital from institutional investors plus the ready availability of debt. These funds fall into three broad types: core, value-added and opportunity.
The report says that rapid growth “saw fund managers launching new funds and raising more capital before they were able to show clear evidence that their funds had provided historic outperformance against market benchmarks or had achieved their set ‘absolute’ performance objectives.
“This is a significant problem for investors – and also for the better managers. Clearly, some fund management houses have been rewarded with performance fees which they may or may not have earned, damaging the reputation of the industry as a whole.”
The authors found that annual total returns of core funds, typically with little or no gearing and investing in prime assets, closely tracked the underlying IPD market index until 2009. Since then they have underperformed the wider market, probably because of the impact of capital flows into and out of open-ended funds, the report says. Leverage accounted for a 1.1% reduction in performance for every 10% of debt in these funds.
However, the affect of leverage was clearer among value-added funds; typically these have between 40% and 60% gearing and generate some of their returns through active asset management.
The report says such funds “significantly underperformed” the market between 2008 and 2011, although they had out-performed between 2001 and 2007. Every 10% of leverage within these funds reduced annual returns by 2%.
Leverage was the source of all the underperformance while fund managers added to fund performance at a property level through asset management (alpha).
Vehicles with higher-risk profiles and gearing over 60%, operating on a deal-by-deal basis, produce opportunity fund returns. In years of abnormal market returns, such as 2005 to 2006 and 2008 to 2009, the relative returns were significantly higher or lower, respectively, than in the core and value-added funds, the report says.
Gearing reduced returns by 2.2% per year for every 10% of debt, equivalent to 13.2% per annum for a 60% leveraged investment.
On a risk-adjusted basis, opportunity funds neither added nor destroyed value at a property level, indicating that leverage was responsible for the significantly high level of underperformance.
Selection of the right fund manager was critical for investors, however. Fund performance differed significantly from year to year and between managers within years, the report found.
A question of rewards
The question of how manager performance is rewarded is therefore a key issue for the industry: for example, do performance-related fees adequately distinguish between risk taking (higher beta) and genuine skill/outperformance (alpha)?
The report concludes that the negative impact of leverage during periods of negative market returns far outweighs the positive impact of debt in rising markets and that debt cannot be viewed as a long-term strategy for delivering returns in excess of core market returns.
“This places great importance on the manager’s/investor’s skill in calling markets. It also raises the question of whether investors had a realistic view concerning the level of risk required to deliver ‘absolute’ returns in mature markets over the latter period of the analysis.”
“Fund managers cannot be held solely accountable for entering the market at the top with leverage, as investors and allocators appeared willing to invest large amounts of capital in these strategies.”
