Downward pressure on hurdle rates in the real estate sector
Article 3 minute read

Downward pressure on hurdle rates in the real estate sector

24 May 2018

The traditional means of evaluating the feasibility of an investment could be playing second fiddle to investor’s appetite for growth and expansion.

Traditionally when evaluating an investment decision, an investment company would make use of either net present value, IRR or return on invested capital to determine a yield percentage. Thereafter this determined percentage would need to be compared to a benchmark percentage, also known as the hurdle rate, defined by Ross et al. (2016) as the minimum expected rate of return an investment must offer to be attractive.

The hurdle rate is usually based on your weighted average cost of capital (WACC - a buildup of equity and debt of the investment company) or capital asset pricing model (CAPM). By comparing the investment yield with the benchmark percentage, the investment company would either accept or decline an investment.

As can be seen in this graph from the IPF Report, the below are the preferred decision-making tools in the real estate sector:

  • IRR
  • Return on invested capital
  • Income on cost
  • NPV
  • Multiple

Preferred decision-making tools in the real estate sector

Hurdle rates in real estate

There are few idiosyncrasies in the real estate sector. The May 2017 IPF report investigates hurdle rates in real estate investments, and it makes three distinctions on how hurdle rates are determined in this sector:

  1. The type of organisation: where’s the origin of capital coming from - from public interest, a pension fund, or private means?
  2. The size of the undertaking of the organisation: larger organisations can more easily absorb a lower hurdle rate.
  3. The style of investment: the risk appetite and exposure to risk of that organisation.

Yet, research done by IPF found that the hurdle rate is not the sort of fully-analysed industry-approved figure one would have expected it to be. Recent experience indicates the shift away from pure mathematical analysis is being driven by shareholders expectations, implying that shareholders are almost dictating an expected rate of return.

Being in touch with the market

Our observation is that the company shareholder - an institutional investor or a pension fund - is expecting a minimum rate of return based on their own investment criteria and what the market has delivered in the same sector. One could raise the question whether shareholders are enough in touch with market movements and conditions to be able to make those demands.

Real estate companies are expanding their global footprint, and therefore exposing themselves to a wider range of fluctuating market conditions. This consequently makes it increasingly difficult to factor in all the variables when determining a hurdle rate for assessing an investment opportunity outside of their own jurisdiction.

Adding to this is that, in order to satisfy the distribution demand of shareholders, real estate companies are accepting lower-yielding investment opportunities by lowering their hurdle rate through the reduction of their risk premium. This is exerting downward pressure on hurdle rates in the real estate sector.

Following this distribution-driven approach, in which risk premiums seem to be less important, combined with fluctuating market conditions could be a short-term solution. However, one does, of course, need to factor in the possibility that omitting certain risks could jeopardise the feasibility and sustainability of a new investment opportunity in the long run.

It therefore makes sense to have a partner on the ground, ensuring that the risk identified in your hurdle rate remains on par with what was identified initially.

Talk to us

When crossing borders, there is a clear need for local partners working with you to reduce risks. TMF Group has the global presence to act as your local partner. We have a proven track-record in the real estate industry, including in fund administration, SPV management, structured finance transactions, accounting and compliance in accordance with local regulatory requirements.

Working with TMF Group can help to reduce risk by managing the information flow across multi-jurisdictional structures. We can control costs by taking care of your back-office administration, and providing you with a single point of contact to help you simplify your operations.

Need more information? Get in touch with us today.

Find out how our services can help you to reach your full investment potential.

Written by

Janco Jordaan and Andries Boshoff

Legal Officer and Senior Accounting Officer

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