CoStar Column: The case for moderate leverage

16th January 2017

With equities and fixed income set to continue to underperform in 2017 relative to past performance we can expect the hunt for alternative asset classes with the potential to generate alpha returns to continue, writes Manish Chande, Senior Partner at Clearbell Capital. Against this backdrop, with global political uncertainty rife, UK real estate is likely to remain a mainstay for investors’ portfolios. Real estate in the UK was valued at £6,400 billion at the end of 2015, offering a range of opportunities for those who identify the right investments to generate alpha returns.

One only need compare returns from corporate bonds with returns from the leases those corporates hold, to see the additional yield that real estate can offer. A 5-year lease to Amazon, for example, shows a 275bps spread over Amazon bonds with a similar term.

However, given the macro backdrop, those investing in real estate in 2017 will need to focus more than ever on applying appropriate leverage, balancing risk and return.

We know that in the past many investors have chosen excessive leverage to boost returns, taking on loan to value in excess of 70%. Of course, this can drive significant returns in positive markets but have the opposite effect in less rosy periods. As we saw during the fallout of the Global Financial Crash, deals based on financial engineering rather than real estate fundamentals can fall apart in harder times and potentially bring distress to the market unnecessarily.

With market volatility becoming the new norm and expected to continue into next year, the case for highly leveraged deals and their associated risk is diminishing. This is not to say we anticipate a correction in the near future, but it is our view that the market does not present the most stable of contexts for pursuing significant leverage.

Indeed, there is a case to be made for applying moderate leverage to deals in 2017. Of course, this will vary per deal and investor. At Clearbell we’ll be targeting leverage within the 15 -50% range.

Voiding leverage altogether would of course be to miss an opportunity to boost returns. But the current market context brings into sharper focus the underlying factors for investment such as income, sector and location. These should be more front of mind when pursuing a deal than applying leverage.

The UK will continue to boast a number of these fundamentals next year, in particular for investors willing to look at opportunities in the potential arbitrage in London and the regions.

If we take advantage of these opportunities, leverage will be a supplement to generating alpha, rather than the principal driver.

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