Leverage almost doubles negative performance in declining markets, according to new research by IPD Japan. The research, which will be presented by Professor Shimizu to the IPD Japan's Annual Seminar 2010 at Tokyo's Belle Salle Yaesu, quantifies the difference between direct real estate investment returns and the Net Asset Value (NAV) returns.
The analysis reveals that over the 12 months to June 2009, a direct property level return of -7.3% was eroded to a leveraged return of -13.4%. At this point, the average LTV was 42% much too high for this phase in the cycle. As the real estate market turned downwards from the middle of 2008, average debt levels continued to rise because asset values fell faster than the managers could delever portfolios. The average fund, in fact, increased its overall debt level at precisely the point when managers should have been de-leveraging.
"The message is clear, but already well known," explains Toshiro Nishioka, Managing Director at IPD Japan, "at some points during a market cycle, the use of debt can significantly enhance the asset level return, but at other points its effect can be devastating. The best fund managers will use debt on the upswing, but will deleverage before the market reaches its peak. In fact, far too many were taking on additional debt at precisely the point they should have been reducing it."
Leverage is traditionally applied to fund vehicles by managers because of its ability to enhance returns in rising markets. This is because the impact of debt is a function of the level of debt, the asset return and the interest rate; positive returns enabled some managers to turn below-average asset returns into above-average fund returns. However, when asset values started to fall, the effect on fund returns, in many cases, was destructive.
Globally and within individual markets, the use of leverage has varied enormously. While cash holdings, fees and exposure to other assets all act as a drag on returns, leverage has by far the most powerful influence. Through much of the cycle, cash was also a drag on portfolio performance, with many funds holding much more cash than they wished to because it was difficult to source investments.
The research is based on Japanese REITs data including direct property assets, other investments, cash holdings, borrowings and interest payments, as well as portfolio costs and fees. However, Nishioka argues that the lessons can be applied across listed and unlisted property funds in Japan and even globally. Nishioka added: "Managers of both listed and unlisted property funds must understand the double-edged nature of debt. Some appear to have acted as if borrowing was a riskless mechanism for increasing returns, but, if they get their timing wrong, exactly the opposite outcome eventuates."