Doing the sums to avoid buying on struggle street

Over the past 16 years, the property market had seen considerable growth. This was driven by the increase in superannuation, almost limitless amounts of cheap debt available and the growth of global investment.

With this growth and the emergence of the funds management industry, the quantitative investment model has gained significant support. While not a new approach in the assessment of property and its value equation, it is now being used to determine not only the current intrinsic value of a property but also the length of time the asset should be held to maximise the investment and meet your return on equity.

The move to the quantitative approach — and its key parameter, the internal rate of return — has altered investment approaches and perhaps forsaken more traditional reasons for investing in property. In simple terms, the superannuation industry does not need cash flow now (as most of its need for cash flow to pay retirees is in the future), it is happy to be cash flow neutral in the short-term and seek to achieve a total return, or an internal rate of return, over an extended investment term.

Quantitative analysis has always been used by developers when assessing development project viability, however, over the last decade it has also become an increasingly important pricing mechanism. A quantitative approach is rules-based and removes much of the qualitative or sentimental approaches. This is good in one sense as it provides a greater consistency across the investment industry, but bad in that everyone understands each other’s pricing decision, hence the highest bidder has pushed their model parameters the hardest and next time, everyone will ratchet up their model to these parameters. Conversely, in a falling market, the bidders will quickly understand the parameter’s failing prices.

A key advantage of the use of quantitative analysis is that it also allows investors to continuously assess the performance of the equity they have within the investment. This will result in a better assessment of the investment at that point in time so it can be compared to other opportunities available. It will also provide the ability to benchmark the performance of equity, which provides an objective view of the performance of the investment.

The quantitative analysis of a property concentrates on the following:

1. The amount of debt and its cost;

2. The income stream and its quality;

3. The time period;

4. Your exit point and predicted yield; and

5. The purchase price and equity investment.

The amount of debt and its cost play a vital part in this analysis. As a result of the credit squeeze, we have seen the cost of debt increasing in all areas. This increase will impact on the geared income stream that can be achieved out of the property. A reduction in this income alone reduces the overall return from the property, however this coupled with the banks’ present requirement for more equity and a lower loan to value ratio (LVR) will impact by reducing the return on equity the investor will achieve.

With this change in the debt component, purchasers are looking at working on other variables within the analysis to achieve their target returns. In the case of existing investments, this may result in looking at a longer life cycle for the investment, provided however that their LVR is consistent with their existing or proposed facility arrangement.

In the case of parties looking to invest, they will be focused on the purchase yield for the asset. As you can see, this presents an interesting situation as the existing owners look to maintain their present value of the investment to comply with their LVR, while those seeking to invest will be forcing yields down to achieve their targeted returns. This is creating a gap between carrying valuations from last year and present market values as determined by the purchasers in the market.

The current market is filled with uncertainty in relation to the extent and length of the credit crisis. Purchasers looking into the future are concerned about what the future value of their current, and potential, investments will be as these future yields will be impacted on by the cost of debt at that time. The net effect of this is that even though that many investments still have a quality income stream, their value in today’s market is reduced due to the balance of the investment equation and the fund manager’s aim to meet their investment criteria and subsequent forecast returns.

The use of a more quantitative approach to property will continue as fund managers and investors look to compare a variety of investment options. While this is only part of the evaluation process, it is a very important step that is required to achieve the investment returns now demanded by the retail investor.

Jason Bennett is the divisional director of direct property at Real Estate Capital Partners.