CBRE’s Four Quadrants: UK private debt provides strongest expected-to-required return spread

By James Wallace - Wednesday, May 16, 2018 13:04

Private debt in the UK currently offers the best value among the four real estate quadrants with expected returns most significantly exceeding required returns, as measured by CBRE’s Four Quadrants Pricing Model.

The model seeks to identify relative value historically and currently by comparing expected returns – the level of return an investment is anticipated to deliver – with required returns – the level of return an investor should demand from an investment, determined by the risk-free rate and a risk premium that CBRE has set.

Current market pricing is captured using relevant datasets across the four quadrants along with income growth forecasts (where relevant). Initially focused on the UK, its scope will be widened to cover Europe in time. For further details on the datasets used in CBRE’s Four Quadrants Pricing Model see the end of this article.

Private Debt

“There is still huge appetite to lend to commercial property across Europe, given private debt’s attractive return profile compared to other fixed income and its defensiveness should suggestions that the underlying market is in a late cycle phase prove correct,” wrote CBRE’s research senior director, Dominic Smith, and author of the latest edition of Four Quadrants entitled, Investors Scramble For Scale.

CBRE writes that the mood is generally buoyant in continental Europe, with lending terms are generally in the low 60%’s and uniformly prudent interest cover ratios and debt yields.

Lenders are also location cautious: Germany, France and Netherlands remain highly favoured, while the growth story in Spain and the scale of the Italian market are also attracting keen competition. CBRE notes that margins in Italy have come under significant downward pressure in the last six to 12 months. Smith adds: “The widening of collateral to encompass more operational real estate offers lenders a little extra in margin in exchange for a little extra risk and will be a popular route for some.”

In the UK, CBRE senses greater lender cautious now that Brexit is less than a year away. However, lending appetite remains as as fierce as at any point in the last 1o years for the very best transactions (property and sponsor), where leverage is up to 50%.

Smith added: “But, underwriting assumptions are beginning to factor in a more doubtful underlying economic outlook. Retailer failures have not helped lift the despondency. We believe some lenders are anticipating an increase in technical defaults should downside scenarios come to pass; while these would not lead in most cases to lenders taking control of collateral, there would doubtless be many instances of renegotiation of terms to allow for higher margins and greater amortisation, given the pressures imposed by Slotting on higher risk loans.”

Public Debt

Currently, CBRE’s Four Quadrants Pricing Model suggests that public equity and private equity also both reflect good value, with expected returns exceeding required returns, albeit to a lesser extent that private debt. Public debt, by comparison, was deemed fair value – where expected returns broadly match required returns. 

This finding is perhaps supported by the significant demand for investment grade CMBS notes which have seen price compression across the capital stack, including notably 75 bps for the €250.0m triple-A tranche in Citibank and Morgan Stanley’s FROSN-2018 DAC transaction, the securitisation of Blackstone’s acquisition finance loan for Sponda, formerly one of Finland’s largest listed real estate firms. The CMBS transaction’s blended coupon was 138 bps compared to 245 bps senior loan, giving a net interest margin of 107 bps which implies “an originator profit of over €20m”, according to estimates by Deutsche Bank’s CMBS analyst team, “and potentially approaching €30m were the loan to run its full course”.

“The economics of CMBS issuance in Europe are now the most compelling in over a decade,” wrote Paul Heaton, CMBS analyst at Deutsche Bank in a note sent on 20 April. What is good for issuing CMBS banks is the opposite for real money investors accepting tighter coupons for the new bonds.

Public Equity

CBRE’s Four Quadrants Pricing Model suggests public equity and private equity both offer good value, with expected returns exceeding required returns.

For those who hold a more bullish outlook for the UK real estate cycle, will perhaps see opportunities in the equity quadrants, CBRE’s Smith suggests, adding that public equity offers the opportunity to buy in at a discount to net asset value (NAV). 

Two recent attempts were Klépierre’s opportunistic takeover attempt for Hammerson last month, at a 45% premium to Hammerson’s undisturbed share price to Klépierre’s offer but 20% below Hammerson’s NAV.  Secondly, Hammerson’s own takeover of Intu Properties, accepted by Intu’s board before Hammerson ultimately walking away, was priced at a circa 30% discount to NAV.While both take overs failed, corporate deals for listed real estate companies are usually at a significant discount to NAV and provide companies with much sought after scale.

Smith explains: “Quantitative Easing has put the investment, or at least the pricing, cycle significantly ahead of the rental cycle, with the result that yields in many European property markets are at or approaching record lows. With income growth solid but not spectacular, and in a few cases at risk of turning negative, pricing can appear stretched.

“With net savers’ capital aggregated into the hands of fewer players, investment appetite is similarly being concentrated; investors want access to an asset class seen as reasonably priced, but they want it at scale and in a form that will deliver the income growth that prevailing yields demand of it. The surge in M&A activity, with the high-profile deals and bids involving some of the largest players in the sector, is a response to the demand for scale.”

Private Equity

Private equity – which is also graded as good value by CBRE’s Four Quadrants Pricing Model with expected returns exceeding required returns – has the advantage of greater income distribution and a level of secondary liquidity that should not be discounted.

Many of the macro themes evident in the public equity markets are similarly visible in private equity, suggests CBRE’s Smith, although there are notable nuances.

He explains: “The theme of scale for example plays out differently in the private equity space. Our secondary trading business, PropertyMatch, observes that balanced funds continue to trade at NAV both in continental Europe and in the UK – this is in contrast to the public equity space where, as mentioned above, REITs are trading at a significant discount to NAV.

“Where new funds are being raised, we are seeing another manifestation of the penchant for scale, in what might be called the property equivalent of the ‘no one got fired for buying IBM’ phenomenon: capital is flowing in very significant quantities to strong fund management brands, even into blind pools.

“As to pricing by strategy, a lack of available data makes it difficult to discern any meaningful change in sentiment for or against core, value-add or opportunistic funds as a cohort. Certainly, individual entities rise and fall in popularity, but as yet there has been no concerted movement, that we can see, against a strategy as a whole.

“This might be expected if the lateness of the cycle and / or a lack of investment product mean that high return strategies, for example, become more challenging to deliver. As the year progresses these investors may face a difficult choice between becoming more aggressive in growth assumptions or returning uninvested capital.”

The four datasets used in in CBRE’s Four Quadrants Pricing Model are as follows:

Public Equity: The FTSE /EPRA NAREIT UK Index

Private Equity: the MSCI Other Balanced Property Funds Indices (CBRE acknowledges that this dataset may not reflect what some people’s views of private equity but states it’s the most relevant in a dataset sparse quadrant)

Public Debt: the Bank of America Merrill Lynch Gbp REIT Corporate Bond series (CBRE has not chosen a CMBS series due to the lack of recent issuance and liquidity in recent years)

Private Debt: CBRE’s own series of senior debt returns derived from its Data analytics service (CBRE concedes its synthetic nature is slightly sub-optimal)

CBRE provides the following disclaimer for its pricing model: “Although this model has shown good predictive power in the past, it may not hold into the future,” wrote CBRE’s Smith, “Investors should use it in conjunction with their own risk and return requirements in mind, as well as their own view of the cycle.”

James Wallace is a freelance consultant and can be reached via Linkedin or email: jawallace32@gmail.com 

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