Leverage: how the smart guys go broke

January 15, 2013 / By  

To quote Warren Buffet, “leverage is the only way smart guys go broke.” Most fund managers will tell you that the shocks experienced throughout Australia’s commercial real estate market in 2007 were not due to a failure of underlying real estate but were a failure of finance. For example, direct real estate values fell by around 2.5% (2007 to 2009) while the AREIT index declined by 70% (IPD).

With the cost of debt now falling to new lows, it seems prudent to revisit some of the fundamental concepts of leverage and how it relates to a commercial real estate portfolio.

During the mid-1990’s the A-REITs had an average gearing level of around 10%. This figure grew to about 40% by the end of 2007. As asset values collapsed, managers were left scrambling to recapitalise their portfolios. It is important to explore the issues that this creates, particularly in a capital constrained environment. Consider a hypothetical portfolio with a 50/50 loan to value ratio (LVR) at a total value of AUD 100 million. If the value of the portfolio declines by 20% the LVR increases to 63%. In order to maintain the original 50/50 LVR the portfolio is required to be recapitalised with an additional AUD 20 million. When asset values began to fall in late-2007 and capital markets froze, investors were left with a significant capital gap. Many of Australia’s listed property trusts were required to undertake significant and very dilutive equity raisings in order to ensure loan covenants were kept intact.

In periods of market up-swings the use of debt can enhance returns, but in a down-cycle it can have the reverse effect. Over the 12 months to Q1/2007 capital values in the Sydney CBD office market increased by 13.5% (IPD). On the down side, over the 12 months to Q1/2009 capital values fell by 10.2% (IPD). When the asset is leveraged with a 60% debt / equity split the returns on the up-swing jump by 3.90% while on the down side the losses are enhanced by 10.30%.

If risk and return have a direct linear relationship and if leverage changes the return expectations of an asset then it is correct to assume that it will also change the risk profile of that asset. To explore this point we have modelled the change in risk (measured as the standard deviation of returns) when leverage is applied to an unlevered asset. Over the past 10 years, unlevered returns in the Sydney CBD office market have had a standard deviation of 13.7%. When we apply a 60% debt / equity ratio the standard deviation jumps by an additional 620 basis points.

Since 2007 Australia’s REITs have restructured their balance sheets, disposed of non-core assets, closed their Net Asset Value gaps and won back investor confidence. With the cost of debt now at new lows, the temptation for A-REITS to once again wade back into debt markets is increasing. Only time will tell if history will once again repeat itself.

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