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On the pulse of the property worldMalcolm Frodsham
Developing a style framework for real estate assets in the City of London
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On the pulse of the property world
04/21/23
Are the interests of investors & managers aligned?
1. Do investors know what they were getting from their real estate investments?– Is there transparency on returns & risks?– Is there transparency about portfolio strategy?– Is there an understanding on the balance between the reliance
on income, growth or leverage to deliver returns?
2. Are the skills and efforts of the managers reflected in the fees?
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Content – A triumph of style over substance?
To move forward the industry needs to develop a style terminology that has substance.– how asset characteristics impact upon
• fund risk and return characteristics• fund strategy• the balance between income and growth• the required level of activity & skill to manage the assets
…and so justify fee levels.
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The wide spread in asset returns …
1. The wide spread in asset returns can be attributed to characteristics such as:– Property type, region, size, location, condition, tenants and
lease structures.
2. Assets with different fundamental characteristics also throw up a range of strategies for asset management:– So portfolio construction can be further differentiated by more
and less risky active management.
So we would expect managers to construct funds which specialise in different bundles of characteristics and active management strategies to produce a span of risk and returns.
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Developing a style framework
• One of the barriers to constructing such style portfolios is a clear articulation of how asset characteristics impact upon their risk and return characteristics.
• This barrier can be overcome if the relevant style factors are overlaid upon:
1. Market sectors.
2. The building life cycle
3. The risk of economic obsolescence of the location
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1. Market Sectors
• High on that list of influences on asset performance are property type, or use class, (shopping centre, industrial, office etc.) and geographical location.
• A long list of other influences on asset returns, however, vary not only within each property type but are also across all types.
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2. Building life cycle
Influences on performance such as leasing structures and depreciation interact through the market cycle, and through the life cycle of buildings.
• A newly completed development should command long lease terms and the best tenant covenants.
• Its leasing risk rises as the asset ages, most abruptly as the first lease expiries approach.
• As the asset ages further it commands lower and lower rents, shorter and shorter leases and weaker and weaker covenants.
• Finally through redevelopment the market timing becomes crucial to performance. Market conditions can generate a range in potential outcomes from huge losses if the market is weak at completion through to massive profits if a favourable market cycle can be exploited through a timely letting.
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3. Economic obsolescence of the location
• Location risk is high when the gap between the rent on a ‘prime’ pitch and a poor ‘pitch’ is great
• Prime pitches are exposed to very low leasing risk as the asset will command long leases, excellent covenants and exceptionally high lease renewal rates.
• The leasing risk is higher for anywhere slightly off pitch: the weaker the pitch the shorter the lease length that can be achieved and the weaker the likely covenant.
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City Offices - volatile
Category Total Return Rental Value Growth
Market weight
Standard deviation % 1981-2010
% Dec 2010
Unit shops: South east 9.6 6.6 7.8
Unit shops: Rest of UK 9.0 5.2 7.6
Shopping centres 9.5 5.5 17.0
Retail warehouses 11.6 4.2 18.4
Offices: City 13.4 14.4 5.3
Offices: West End 14.6 14.8 11.8
Offices: South east 10.5 8.6 7.7
Offices: Rest of UK 10.1 7.4 4.7
Industrials: South east 11.2 7.3 8.4
Industrials: Rest of UK 10.7 5.8 6.1
Other 9.6 6.6 5.3
All Property 100
• City Offices have generate volatile performance – mostly from rental volatility
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City Offices – return characteristics
• City Offices have generated poor returns to investors
• Investors could avoid the market and risk short periods of underperformance – are some assets lower volatility or higher return?
• Investors could seek to ‘time’ the market – want to identify assets that benefit most in the recovery
Category 1981-2010 Total Return, % pa
Maximum 5-year out-
performance, % pa
Number of 5-year out-
performance periods
Unit shops: South east 10.0 4.0 13
Unit shops: Rest of UK 9.6 4.3 11
Shopping centres 9.4 3.4 14
Retail warehouses 12.0 12.3 20
Offices: City 7.8 5.2 7
Offices: West End 9.7 7.1 15
Offices: South east 7.0 0.8 4
Offices: Rest of UK 8.5 7.2 7
Industrials: South east 10.4 7.2 16
Industrials: Rest of UK 10.3 12.6 13
Other
All Property
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City Offices - Sample
• The IPD databank contains the financial records of 1,920 individual City asset holdings with a predominantly office use held in 97 separate portfolios.
• Each asset record spans its holding period within the databank; this is from either the purchase date or the start of the IPD portfolio record (the earliest date being January 1981) to sale date, the end of the IPD portfolio record or, if still held, to the end of 2009.
Asset
characteristics
Financial characteristics Performance characteristics
Floor space Estimated Open Market Rental Value
(OMRV)
Total return
Construction date Capital value Income and capital components of
return
Address Capital expenditure Rental and yield drivers of capital
growth
Yield
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City Offices - Sample
• The average size of City of London office assets in terms of floor space held by portfolios in the IPD databank has trended upwards from 1981 to 2010 with a notable rise in the 1990s from about 4,000 sq m to 6,800 sq m.
• The average holding period of all City of London office assets in the IPD databank from 1981-2009, with both a purchase and sale record, has been 10.4 years with 44% of assets held for less than 5 years, 28% held for longer than 10 years and 14% for more than 20 years.
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City Offices - Sample
• When adding the sample of assets either held at the start of the measurement period or assets that were still held at the end of 2009 the average measurement period is 7.0 years with 52% of assets with a measurement period of less than 5 years, 24% of assets more than 10 years and 3% of assets more than 20 years.
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City Offices - Average ERV per square metre
• The highest average ERV per square metre on the stock in the IPD Databank was recorded in 1989, the peak in the mid-eighties cycle. This peak has not been bettered in any of the three subsequent cyclical peaks in 1990, 2002 and 2008.
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City Offices - Quality
• Our aim is to split our sample according to the ranking of each asset’s ERV per sq m.
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City Offices - Quality
Quality percentile ranking (based on ERV per square metre)
Quality bandCore > 75%
Opportunity < 25%100% Core95% Core90% Core80% Core
70% Value add60% Value add50% Value add40% Value add30% Value add
20% Opportunity10% Opportunity
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City Offices – A stabaliser
• To prevent assets switching excessively from one property band to another and then back again a ‘stabilising formula’ has been used.
• This stabilising formula uses both the current and previous month’s observation such that;– An asset which was allocated to the core category in the previous
month can only move down to the value add category if its ranking consequently falls below the 65th percentile or down to the opportunity category if its ranking falls below the 20th percentile.
– An asset which was allocated to the value add category in the previous month can only move up to the core category if its ranking subsequently goes above the 85th percentile or down to the opportunity category if its ranking falls below the 20th percentile.
– An asset which was allocated to the opportunity category in the previous month can only move up to the core category if it’s ranking subsequently goes above the 85th percentile or up to the value add category if its ranking goes above the 35th percentile.
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City Offices – Location quality
• Location quality is usually described as either ‘core’ or ‘fringe’ but no external definition exists to categorise each asset.
• Locations within the City command varying premiums from occupiers. These premiums are linked to the prestige of the address, the proximity to transport infrastructure and other geographic features.
• The choice of the number of location grades has been subjectively set at two, mostly to mirror market practice; ‘core’ and ‘fringe’. These locations are not required to be physically contiguous.
• Locations are defined by the first digit of the second half of the postcode. There were assets in 139 such postcode areas.
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City Offices – Location quality
• To initially allocate locations as core or fringe, a simple average of the rent per square metre on all assets in the same postcode area were calculated for each postcode area in the 80s, 90s and 00s.
• The allocation of each postcode area was then the subject of individual scrutiny looking at assets within the databank that have been developed in that postcode area. If there was evidence that a new asset had commanded an average rental value per square metre in the top 25% of all existing office assets in the city then the area was designated as core.
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City Offices – Asset Style
• Assets are allocated to each quality band in both the core and fringe locations separately.
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Provisional results – Total Return
• As required Value add out-performs Core with additional volatility of return.
• Prime opportunity does not out-perform value add but fringe Opportunity assets do – and with lower risk
Average Volatility
Prime Fringe Prime Fringe
Total Return
Core 7.2 6.9 13.0 14.2
Value Add 7.7 7.6 13.9 16.5
Opportunity 6.4 11.2 15.1 16.1
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Provisional results – Income Return
• As expected core assets have a lower running yield.• Opportunity assets have extensive vacancies created for
refurbishment / redevelopment.
Average
Prime Fringe
Income Return
Core 5.8 6.3
Value Add 6.8 7.8
Opportunity 6.5 6.8
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Provisional results – Rental Growth
• .
Average Volatility
Prime Fringe Prime Fringe
Rental Growth
Core 0.4 0.9 13.1 15.0
Value Add 1.5 2.6 15.5 18.1
Opportunity 1.4 0.2 17.1 18.2
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Summary – A triumph of style over substance?
The recent cycle has demonstrated the need to create a style terminology that has substance to align the interests of investors and managers.This requires the ‘sorting’ of assets into funds to be based on both sector and the life cycle of assets.– This will provide:
• Transparency on expected fund returns & risks• Transparency about fund strategy• Transparency on the reliance on income or growth to
deliver returns– And allow fees set to reflect the skills and efforts of the
managers…although perhaps low liquidity & high transaction costs will always prevent the creation and delivery of style based funds to investors by managers?
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Summary – Provisional UK City Office results
Initial results for UK City Offices meet requirements for:– A higher volatility of returns for Opportunity and Value Add
assets– The return from Value add to be driven by rental growth
following capital expenditure– The return from prime Opportunity has been poor – especially
the risk adjusted return
The results are a stepping stone for an asset style typology
...but much, much more to be done even on City offices let alone extending to other sectors and regions and countries.
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Thank you for your time
IPD
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London, EC1M 4BL
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Email: [email protected]
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Intellectual Property Rights and use of IPD statistics as benchmarksWhether in the public domain or otherwise, IPD's statistics are the intellectual property of Investment Property Databank Limited.It is not permissible to use data drawn from this presentation as benchmarks.
© Investment Property Databank Limited (IPD) 2008. Database Right, Investment Property Databank Limited (IPD) 2008. All rights conferred by law of copyright and by virtue of international conventions are reserved by IPD
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On the pulse of the property world
04/21/23
Business space
New Mid-life End of economic life
Development
Exposure to risk
Leasing risk Low Medium High Very High
Market risk Low Medium High Very High
Portfolio characteristics
Yield Low Medium High No income
Expenditure None Low Medium Very high
Vacancies Very Low Low Regular No income
Covenants Excellent Good Poor n/a
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Performance generating strategies – Business space
New Mid-life End of economic life
Development
Income versus growth
Achieving high rental growth
Balance of high rental growth with higher yield
High running yield
Timing the rental cycle
Leasing No scope Lease re-gears Keeping the income coming
in
Achieving the longest lease and covenant
strength
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Styles in the Office Sector
CORE• New Assets• low income risk / low market risk• Select ‘growth’ assets• Portfolios constructed of predominantly
new fully let office and industrial buildings will be exposed to low vacancy risks and performance will come from selecting growth assets that achieve high uplifts at rent review.
• As rent reviews are driven by market rental levels for similar assets in the location the portfolio manager needs to ensure that the assets acquired are in locations that can deliver rental growth to generate strong performance. .
CORE+• Older assets• Moderate income risk / moderate
market risk• Maximise re-lettings / re-gears• Portfolios of assets where unexpired
lease terms are shortening but the asset is still potentially capable of achieving another long lease are exposed to the re-letting risk which is also highly correlated with market risk.
• The portfolio manager will be seeking to identify assets in locations that can achieve long new lease lengths and therefore minimise vacancy periods. Lease re-gears and tenant retention strategies are typical fund manager tactics for such assets. Often managing the dilapidations is the key to minimising costs.
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Styles in the Office Sector
Value add• Poor quality assets• High income risk / high market risk• Maximise occupancy / minimise costs• Portfolios aimed towards older office
and industrial stock will be exposed to regular re-letting risks. Often buildings have to be let with multiple occupation and covenants are weaker and lease lengths shorter. Portfolio costs are higher as assets will require expenditure to maintain the buildings in ‘let-able’ condition. Managers are required to be very active in keeping the assets income producing and minimising the costs.
• Poor quality portfolios can also extract higher returns from planning gains and preparing
Opportunity• Developments• Maximum income & market risk• Market timing and development skills• The risk of an asset massively
increases once entering its development phase as capital has to be committed prior to a lease being secured. If a pre-let can be achieved then the risk is removed and ‘only’ construction risk remains. Market risk is extremely high as the rent achieved upon completion will determine the return on the expenditure and the gap between committing to the development and completion exposes the asset to the risk of rental value falls.
