Like an albatross around its neck, it seems the private equity real estate community always must be reminded of the dangers of leverage. In the most recent riposte, the Urban Land Institute (ULI) issued a report last month suggesting that leverage used between 2001 and 2011 reduced returns by up to 13.2 percent for a 60 percent leveraged opportunity fund. The report calculated that gearing led to a reduction in returns of 2.2 percent per year for every 10 percent of debt in a fund.
The research by the European arm of ULI, entitled Have Property Funds Performed?, feels old in a sense. More contemporary debate concerns the lack of debt supply rather than its overuse. Indeed, it has been that lack of supply by traditional banks that has opened up a €147 billion void, a useful by-product of which has been the creation of a whole new discreet asset class, namely real estate debt funds. But I digress.
Old though it may be, the over-leverage of opportunity funds is still painful. Investors still are nursing their wounds from previous fund investments that were over-juiced, and they continue to watch managers de-lever assets, portfolios and whole funds and hopefully recover value where possible.
Given the pain, it is a useful exercise to measure the wound, which is what the ULI report purports to do. Its author, Andrew Baum, first investigated the topic for ULI in 2010, looking at the timeframe of 2003 to 2009. This new report is a follow-up to that, looking at the slightly longer period of 2001 to 2011.
The report concludes that, especially during the 2008 to 2009 period, the impact of leverage was so punitive it undid most positive results achieved by managers, even though some opportunity funds did achieve alpha results. From 2001 to 2006, value-added and opportunity funds were found to have delivered higher returns during a rising market than core funds, but opportunity funds significantly underperformed both core and value-added strategies over the entire decade. In fact, adjusted for risk – a key metric for investors – opportunity funds came in last for every period it analyzed.
The math is straightforward, of course. If you have a property worth €100 million and the market goes up 40 percent, your investment gains value to €140 million. If the market then falls 40 percent, you end up with an €84 million investment. If one uses leverage, however, it gets a bit tricky.
Say the fund is 80 percent leveraged and therefore buys the property with €20 million in equity and €80 million in debt. If the market rises by 40 percent, you again have a €140 million property, but you also have €60 million in equity value and a great return on your hands. If the market then goes down by 40 percent so the property is worth just €84 million, you still have €80 million of debt but your equity is 80 percent wiped out even though the market went up and down by the same amount.
That’s the danger of debt: the worse the performance, the more money the underlying investors lose. Because markets did go up and down by roughly the same amount in the mid-naughties and there was a lot of leverage, a huge amount of capital was destroyed.
Of course, there is a flip side to that same coin, which is that leverage leads to better performance during an upswing, as everybody knows. The report therefore provides something else other than a whip to flay us. If right now you believe that values will rise in the future for certain assets, particularly for stressed assets that can be worked out, then you would want to put more leverage on to make more money.
Indeed, one can look at the US and the hedge fund world to see that this is going on right now. Hedge funds are loading up on record levels of debt to make money off the New Year rally in stocks.
The problem, however, is that it is still difficult to get highly leveraged in Europe. Plus, there is the danger of volatility. Are values rising or oscillating? Investors, meanwhile, either don’t want leveraged funds or aren’t allowed to have them.
If conditions begin to look right, maybe opportunity funds will leverage up again. In that case, in 10 year’s time, the update to the ULI research might very well show how opportunity funds were able to outperform core and value-added funds significantly between 2011 and 2021. The optimist would like to think this will be a golden vintage.