One of the core themes of the Cambridge Finance’s course REITs – Investment in Real Estate Securities is indeed: What’s the value of a listed real estate asset? Our belief is that as markets trade on disagreements about the value of assets, the valuation process should be a crucial point in any investment course.
However, before we start, we want to highlight that a valuation exercise is an exercise of consistency and coherence. We call these the two pillars of the valuation exercise. On the course, you will understand better what this means but we want to draw your attention to this now. Thus, if the variables used on the different phases of the valuation are not coherent amongst themselves, the valuation output is not to be relied upon.
In this article, we will develop our thinking on the cost of equity and the risk-free rate as these underpin our framework for REITs’ valuation.
So, what does ‘cost of equity’ mean?
The cost of equity is the return that shareholders require for their investment in a company, given its risks profile. The basic principle is that shareholders require a higher return for riskier firms than for safer ones. Risk can take many different forms: business, leverage, operational, liquidity, bankruptcy or truncation, political, etc. Although many of these risks are interconnected, we will focus our attention on the business and leverage risk.
Business risk is related to the nature of the underlying business where the company operates and affects the companies’ revenues and cost structure. Leverage risk is introduced by the debt capital raising policy and has an impact on the net profit of the company.
With everything else constant, equity investors require higher rate of return for companies that operate in segments that are discretionary (non-essentials, such as luxury goods) and companies with greater leverage (higher debt levels).
How do I calculate the cost of equity?
There are several methods to calculate the cost of equity. The mainstream methods are: the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing model and Multi-factor models. Although based on a different set of assumptions, these methods have the following common factors:
- They use a risk-free rate as a base return;
- They use a relative risk measure to factor in the risk of the company
- They assess the risk premium as basis for valuations
As a starting point, what is the risk-free rate?
Although the name is less descriptive these days than it once was, governments’ securities are often called a risk-free rate. This happens because we do not expect the government to default and the actual return on the investment equals the expected return if the security is held to maturity.
A risk-free rate has:
- NO variance around the expected return (if held to maturity)
- NO default risk (which nowadays is hard to say about all developed countries)
The CAPM, for example, defines the cost of equity as:
- Cost of Equity = Risk-Free Rate + Beta * (Market Return – Risk-Free Rate)
As risk-free rates have a term structure, it is important to understand the duration of the asset being valued so we can use a coherent risk-free rate. For example, as companies/REITs are long-term assets, the risk-free rate used for the equity valuation should use the yield of a long-term government bond…
Which long-term government bond should be used?
The importance of this decision is a function of the interest rates term-structure. If the term-structure for longer-term government bonds is flat or close to it, you will be somehow indifferent to use a 10, 20 or 30 years’ bond yield. However, if the interest rate curve is upward or downward slopping, it becomes important to assess the investment horizon and then you will need to select the bond yield that has similar duration to your holding period.
The chart below shows the UK Government bonds term structure as of 31 October 2016.
UK Government bonds term structure
Source: Financial Times
Investors tend to use the yield on the 10-year bond as the risk-free rate, which will also be our benchmark and was 1.25% on the 31 October 2016.
It is important to highlight that, although risk-free, the UK government bonds yields change over time to capture current market sentiment and expectations. The chart below shows historic values of the 10-year UK Gilts from January 2000 to 31 October 2016. You will note that this is not as stable as one would expect. The 10-year Gilts yields have fallen from 6% in January 2000 to below 1% in September 2016.
10-Year UK Gilts Yield
Source: Bank of England
Current yield or historical average yields?
Since central banks have become more active in the bond markets, many commentators have been advocating the need to dismiss the current spot yields and look at alternative methods to calculate the risk-free rate. We don’t want to take part of this discussion but we want to remind you again the two pillars of the valuation exercise: consistency and coherency.
For example, if you believe that the risk-free rate should be 4%, which will be translated into a higher cost of equity and lower valuation, you are also assuming that the economy’s long-term growth rate will be 4%. If the long-term growth rate of the economy is 4%, to be consistent and coherent, the valuation exercise should assume that the long-term growth rate of the company is also 4% (otherwise, the company will either disappear or become the economy). Thus, although the cost of equity is higher, the expected cash flows or terminal value of the company will also be higher and, thus, the valuation outcome should remain unchanged >> Consistency and Coherence!!
What is the impact of Brexit and Trump on the long-term risk free rate for valuation purposes?
Adjusting your valuation models to incorporate surprise shocks such as Brexit and Donald Trump’s election is a difficult task: contradictions are fierce. Will inflation go up as protectionism means re-inventing the domestic manufacturing industry at a higher cost? Will growth be deterred as borders against global trade will be placed everywhere? What about the effect of the more nationalistic immigration policies on labour cost and domestic demand?
It is hard to be consistent and coherent these days, when all expectations are thrown out of the window by the current political instability. But thinking critically on the effects of economic policies may help you develop the exercise (and perhaps, we should create a course on political science instead…)
What is the risk-free rate of an emerging market or a Euro country?
Unfortunately, not all government securities are risk-free. Since some countries cannot print money or have to issue debt in a foreigner currency, the government securities yields carry some credit risk premium. Investors demand this premium to cover for expected losses on default. Therefore, for these countries:
Risk-free rate = Bond yield – credit risk premium.
The credit risk premium can be calculated by:
- Looking at the country’s credit rating and using the rating agencies matrices to convert the rating into a credit spread.
- Finding the credit default spread (CDS) of the country.
- If the country has long-term outstanding Dollar or Euro denominated bonds, by:
Default spread = $ (or €) bond yield – US bond yield (or Bund yield)
Why are risk-free rates different across countries?
The chart below shows the 10-year bond yields for a number of countries and spreads over US and German 10 year bond yield on 31 October 2016. Although, for some countries (like Greece, Portugal, Italy,…), it can be argued that the spread carries some credit risk, for other countries this argument isn’t valid.
Countries’ bond yields & spreads over T-notes and German Bunds for relevant countries
Source: Financial Times
Why is the 10-year German Bund yield 0.16%, the 10-year UK Gilt yield 1.2% and the 10-year US T-note 1.8%?
The yields are different because investors have different expectations for the inflation rate on these countries. Countries with expected higher inflation rates will trade at higher yields to compensate for the loss of purchasing power.
Hopefully this post has given you an overview of asset valuation for REITs and how we will discuss its components on the course. The idea is to give you tools to make your valuations consistent and coherent and applicable to the real investment world.
Our next post will be about the market risk premium and after all, we should be confidently answer: What are the costs of equity of British Land? Unibail? Land Securities?
Written by Dr. Ricardo Pereira, Partner at InProp Capital and Real Estate Securities Expert, and Maria Wiedner, CEO of Cambridge Finance.