Dr Neil Turner argues that differences in depreciation levels and spending on portfolios across Europe make it hard to compare like with like. So what hope for establishing global standards for measuring performance?
With the fund management industry keen to move towards a set of global investment performance standards (GIPS), it is timely to look at whether such a goal is realistic.
Our research adopted an unusual perspective on property investment by examining parallels between the level of earnings retained by quoted companies and the way property investment performance is measured and delivered. It is widely accepted that the level of retained earnings of a quoted corporate will have an impact on its earnings and dividend growth.
To varying degrees across European office markets, property fund managers adopt full (or near full) distribution policies. In the UK, for example, tenants are responsible for maintenance, repairs and other costs. The rent paid and distributed to investors is triple net, and typically none is retained to fund property improvements. In theory, this will lead to higher rates of rental value depreciation.
But is this supported by evidence? We looked at several European office markets across which the effective retention of earnings varies. We then compared depreciation rates across these markets as a direct proxy or driver of rental growth. Our research was based on two hypotheses:
1. The City of London could be expected to experience lower recurring expenditure than other European cities, partly due to the inflexibility of the lease structure.
2. There are differences in the rate of office estimated rental values (ERV) depreciation between the City of London and other European office markets. The higher levels of spending in European centres would be expected to offset ERV depreciation.
To test the first hypothesis we determined the average annual amount (revenue and capital expenditure) landlords reinvested in their office portfolios in central London, Stockholm, Frankfurt Amsterdam and Paris. For London we undertook the exercise separately for single-lets and multi-lets. The aim was to arrive at an annualised reserve of revenue and capital expenditure incurred by landlords to maintain occupancy levels and the competitiveness of their portfolios.
For the second, we excluded any property built before 1960, on the basis that older buildings do not age as rapidly, and any analysis would be skewed by their age.
We found evidence to support the theory that revenue and capital spending incurred by office portfolios varies across European markets. Paris has only a marginally higher earnings retention rate than the London single-let sample, but all other European cities have retention rates of more than double the UK single-let sample. The UK single-let sample’s lower retention rate is probably related to lease structures in the UK, characterised by long, net leases.
The difference between the London mutlilet and single-let sample is also worth mentioning. The multi-let earnings retention rate appears to be more than twice as high as the single-let sample. This is perhaps explained by the reinvestment opportunities offered by mutli-lets.
We found evidence to support the hypothesis that ERV depreciation should be lower in other cities than in London. The profiles show declining rental values in broad terms, with ERVs falling as building age increases. There is also a link between the estimates derived for rental value depreciation in each market and the computed earnings retention rates.
The UK single-let and multi-let samples experienced average ERV depreciation rates of 2.45% and 1.10% respectively. It is worth noting that the single-let sample experienced rental value depreciation over two times that of the mutli-let sample.
The Paris and Frankfurt office markets experience higher earnings retention rates than the UK sample and, again, we find lower rates of rental value depreciation. The Amsterdam and Stockholm samples exhibited retention rates of over 1% – both double the UK single-let sample. They also experienced the lowest rates of rental value depreciation. The rental value profile by age-band for the cities looks very different to the other cities. This may be to do with the fact that these markets, particularly at the end of 1999, were fundamentally under-supplied, with demand driving rents ever higher for older stock.
This work shows that the world of property investment performance measurement is highly complex. Trustees and their advisers will need to look beyond single measures, as in the real world, comparing investments is a very different matter.
GIPS will identify meaningful elements of property performance – such as the need to split income and capital growth and not just provide a statement of total return. But do we need to go further than this? Income returns are computed after deducting annual costs. But if these are different between international markets, due to different lease structure, is the income return comparison valid across markets?
A more fundamental question is whether there is an earnings retention rate which maximises long-term performance for offices – and if so, what is it?
Dr Neil Turner is portfolio manager, Europe, Alecta Investment Management. This research was undertaken with Ian Cullen and Tim Horsey at IPD and Professor Andrew Baum of the Department of Land Management, University of Reading
