Many European listed property companies appear to be more reactive than strategic in their major capital budget decisions when acquiring investment properties and undertaking development projects and aren't making full use of the sophisticated analytical tools available to them, the preliminary findings of the European Public Real Estate Association's (EPRA) first Capital Structure Survey indicate.
Colin Lizieri, Grosvenor Professor of Real Estate Finance at the UK's Cambridge University and lead author of the survey said: "We certainly formed the impression of an industry reacting to market conditions, rather than using strategic planning, and one that is not making the best use of the analytical tools available to help it with crucial capital allocation decisions. I need to stress that these are preliminary results and further analyses of the survey's implications need to be undertaken."
The EPRA/Cambridge Capital Structure Survey was conducted in July and August, 2010 among European property companies. A total of 44 firms with a market capitalization of 72 billion responded to the survey, which represents around 88% of the market capitalization of the EPRA European index. REITs (Real Estate Investment Trusts) and non-REITs were equally represented in the sample.
The main conclusions of the survey are detailed below:
In taking investment and development decisions, the majority of firms used discounted cashflow methods. Internal Rate of Return was generally preferred to Net Present Value, despite the former's technical shortcomings. Many firms still employed ad hoc decision-making tools such as payback or income on cost ratios. There was no evidence that advanced analytic approaches using real options models, VaR or EVA were widely adopted in the European property industry.
Mainland European property firms generally used lower risk premia than UK firms; REITs used higher risk premia than non-REITs. The levels quoted by firms seem very high, suggesting that they might struggle to justify acquisitions without bullish rental growth assumptions.
Over 25% of firms stated that they did not estimate their cost of equity: in turn this implies that they are either not using or not updating their Weighted Average Cost of Capital. REITs tended to use more sophisticated capital market estimation models than non-REITs.
Most firms adjusted discount rates for specific assets and projects. The factors determining that adjustment were typically at individual asset level driven by microlocation, building factors or tenant covenant. The factors typically used to structure portfolio allocations sector and geography were lower rated.
Most firms had some form of Debt/Equity ratio target: European firms typically had stricter target ranges, while UK firms had more flexible ranges or no target at all. This allows them to be more tactical and opportunistic, but also determines that they must be more reactive and vulnerable to market shifts.
By contrast, few firms appeared to have strict targets for average debt maturity. Some 27% of firms (and 21% of REITs) had no target at all. There was some evidence that firms preferred longer term debt, both to reduce refinancing risk and match the maturity of asset, project life and lease length.
The major factors that determined a firm's level of debt appeared to be typically reactive rather than strategic. Some 83% of firms cited loan to value and other financial covenants; 60% of firms cited interest rate coverage ratios as determining debt choices; a further 40% reacted to the cost of equity in the market. It is not clear whether this represents a reaction to recent debt and real estate market conditions, or represents a structural reluctance to follow long-run approaches to capital structure.
The sense of an industry reacting to market conditions is confirmed by a strong preference at a project funding level for the cheapest forms of capital available at that point. About 70% of non-REITs opted for the cheapest form, with just 25% having a defi