Risk can be classified as systematic or unsystematic (idiosyncratic). Systematic risk is the risk inherent to the entire market. The idiosyncratic risk, on the other hand, relates to the risk associated with the individual asset. Modern Portfolio Theory argues idiosyncratic risk can be reduced through diversification. However, management of the idiosyncratic risk can assist real estate investors in surpassing benchmark returns for that sector or grade of real estate.
We have split idiosyncratic risk into two sections – fixed and variable. Fixed idiosyncratic risks are assessed at the time of acquisition. These include the asset’s location within the market and the basic characteristics of the asset. Some of the basic characteristics include: floorplate size and configuration, location of the service core and floor-to-ceiling height.
Other idiosyncratic risks are variable. The WALE, rental profile (over/under rented), capital expenditure requirements and tenancy profile change over time. Investors dedicate a high proportion of the due diligence process to understanding these idiosyncratic risks.
One variable idiosyncratic risk, we believe, investors spend insufficient time on is covenant quality. Major ratings agencies – Standard & Poor’s, Moody’s and Fitch – produce credit ratings which express a relative ranking of creditworthiness. The primary factor relates to the likelihood of default. Standard & Poor’s associate each successively higher rating category with the ability to withstand successively more stressful economic environments. Ratings produced by Standard & Poor’s range from investment grade (AAA to BBB-) to speculative grade (BB+ to D).
The corporate bond market in Australia is relatively shallow compared to other mature economies. However, there is sufficient depth in the market for adequate price discovery. At the end of November, the Reserve Bank of Australia published a corporate bond yield of 3.76% for a AA-rated corporate compared with a 4.73% yield for a BBB-rated corporate. Fixed income investors, therefore, require almost 100 basis points of additional yield to compensate for the additional risk associated with a BBB-rated corporate.
Assume we have two identical office buildings – Asset A has a 10 year lease to a AA-rated corporate, while Asset B has a 10 year lease to a BBB corporate. The corporate bond market would suggest the acquisition price on Asset A should reflect an equivalent yield 100 basis points tighter. Not necessarily. If the tenant in Asset B defaults, the investor is left with a physical asset which can be re-leased, unlike the fixed income investor who is left with a (metaphorical) piece of paper and a long line of creditors ahead of them.
Nevertheless, the difference in covenant quality and ultimately security of income should reflect a pricing differential. Somewhere between 25 basis points and 50 basis points seems plausible. However, in the current investment market, where the demand for assets with long lease terms is high, property market investors are not adequately assessing the covenant risk and discriminating between corporate creditworthiness.
Andrew Ballantyne is Head of Capital Markets Research for Jones Lang LaSalle in Australia, based in Sydney.
