A bull market, a time of rising values and improving cash flows, is not a point in the property cycle at which investors are overly pre-occupied by the capital structure of their deals.
But as we move further on through the cycle in Europe, this is arguably an important piece of the equation. It requires more attention while there is capacity in the capital markets to do so.
In the recent past, real estate has had it good, pretty much since the easing of the eurozone crisis in 2011-12, even if it has not always felt like it. The bounce off the bottom, propelled by quantitative easing, may have come at different rates in various countries and sectors, but the direction of travel has been the same.
Lately, though, things are beginning to feel different. This year has started with investors becoming more cautious as they ponder the sharp slowdown in growth in China and other emerging markets, falling oil and commodity prices, the continuing instability in the Middle East and the US Fed tightening monetary policy. In financial markets, equities have dropped, credit spreads have gone up and volatility has risen.
This is the backdrop to the property markets, where the weight of capital has driven yields back down to 2007 peak-market-levels, especially for prime assets in the UK, sometimes in anticipation of rental growth. It means that the number of opportunities left in which investors can buy, gear up, then sell and generate a healthy return from yield shift is dwindling. Real estate investors are increasingly turning back to basics as we move from a pure capital markets cycle into a new phase that is more about investing for income growth and asset managing effectively, or about the “buy-fix-sell” model based on the expectation of improving income through repositioning and rental growth.
At such a point, getting capital structures right will be crucial. The most appropriate structures are likely to be ones that maximise the efficiency of the flow of returns to equity rather than focus on capital returns. They need to be based on business plans that reflect realistic suppositions about the evolution of local property cycles and market liquidity.
Debt should be appropriately positioned in any structure both in amount and term as it can help to achieve target returns. At the moment its cost is low compared with the recent past, and it is widely available.
Too much leverage, though, may not be appropriate if it exposes equity not only to simple leverage mathematics when yields move up, but also to a risk of dilution in favour of debt if reality diverges from the business plan. Declining cap rates improve leverage ratios but they do nothing to help service the debt payments.
Appropriate structuring is not all about the negatives, but investors of all types need to be aware of the risks and factor them in. Even strategies like retail to wholesale asset aggregations of multifamily housing or logistics, which are valued highly for their diverse and secure income and attract low debt margins, could be exposed in a rising interest rate or falling rent environment.
As history tells us on more than one occasion, macro-economic changes can affect what were accepted structures in real estate. We have seen international investors in core assets use debt because of the currency hedge and its tax advantages. But the recent rapid fluctuations in exchange rates and projected changes by the OECD in the ability to offset interest for tax might necessitate a rethink.
I believe there will continue to be plenty of opportunities if we stay focused on the nuances and gradations of risk as the market evolves. And as it does, it will be investors who use well-designed capital structures that are resilient and which fit the sources and evolution of returns, who will continue to do well.
