Business School

ACTL4303 AND ACTL5303

ASSET LIABILITY MANAGEMENT

Week 6
Property, Private Equity and Hedge Funds

Greg Vaughan
Institutional Property
• Commercial, usually CBD differentiated by grade (A, B,C,
D)
• Retail centres (eg Westfield) categorised by number of
department stores, supermarkets and specialty shops.
• Bulky Goods centres (eg Bunnings) are a separate retail
category
• Industrial categorised by function – warehouse, distribution,
industrial estate , high-tech business park
• Also miscellaneous specialist properties including hotels,
carparks, conference centres

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Investment considerations
Aside from LOCATION, other investment considerations
include:
• The forecast levels of new supply of that property type in
the area
• The quality of tenants (eg public sector often avoided)
• The Weighted Average Lease Expiry (WALE) – is there
vacancy risk on lease expiries?
• Is the property in need of substantial refurbishment in the
near term?
• Are there zoning options available (eg dual
commercial/residential)?
• Will transport network developments affect location?

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Property terminology (1)
• Outgoings – property rates, insurance, repairs and
maintenance.
• A lease can charge a gross rent where the landlord pays
outgoings, or a net rent where the tenant pays outgoings.
Either way the tenant effectively pays outgoings and the
landlord receives net rent after outgoings.
• A leasing incentive is a benefit, usually confidential, offered
to a new tenant (eg four months rent free)
• Effective rent = face rent – incentives
• ‘Passing’ rent is a term used to distinguish from market rent
where current rent is above or below market

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Property Terminology (2)
• Retail leases usually consist of a base rent and a
percentage of turnover which applies beyond a break-even
level. On review the base rent and break-even will reset to
recent levels.
• Occupancy Cost is the total cost incurred by a tenant to
provide for there occupancy including net rent, outgoings,
capital costs, depreciation allowances.
• Vacancy rate is the proportion of empty but occupiable
space (high vacancy rates indicate oversupply)
• Occupancy Cost Ratio (OCR) is total occupancy cost
divided by gross turnover (retail property). When OCR is
high landlords face greater risk of higher vacancy rates

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Accounting Definitions for REITS (1)
• Net Income = Rent – management and operating expenses
– depreciation of capital improvements
– amortisation of lease incentives
– interest
• Funds from Operations (FFO) seeks to remove non-cash
adjustments and get back to an operating income concept
FFO = Net Income + Depreciation + Amortisation
• As an accounting concept this ignores important
adjustments. Adjusted Funds From Operations (AFFO)
replaces depreciation and amortisation with current cash
equivalents, similar to equity free cash flow concept
AFFO = FFO – current capex – current lease incentives

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Property Valuation
Three basic approaches:
• Comparison to similar buildings that have sold recently,
although no two properties are identical
• Summation – land value plus cost of improvements. Useful
when building is new
• Capitalisation of net income. Calculate net income and
capitalise at the appropriate market capitalisation rate for
the property, (Net Rent)/(Capitalisation Rate)
Properties are valued for ‘highest and best use’ which may be
different to their current function.

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Property Valuation – Capitalisation of Net Income
• The capitalisation rate is similar in concept to the dividend
discount model, V=Net Rent/Capitalisation Rate
• Typically new tenants are given incentives usually in the
form of a rent free period at the start of the lease
• This assists a new tenant with the cost of fit-out
• The valuation typically applies a capitalisation rate to net
income = rent after outgoings but before incentives
• The capitalisation rate may be increased as an allowance
for the artificially high net income (ie the owner doesn’t
actually receive income during the incentive period)
• The calculation may be further adjusted for expected
capital expenditure in the short-term (eg two years)

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Capitalisation of Net Income is not a DCF
• Properties need to be redeveloped periodically
• This involves a substantial investment (eg 10-15% of value
every 10-15 years) to ensure rents are sustainable.
• And probably a rebuild every 40-50yrs
• Allowing for this capital expenditure is equivalent to a
reduction in income of circa 1.0% pa.
• The implied return from property investment is
approximately the capitalisation rate + rental growth –
allowance for capex
• For example with Cap rates at circa 5% and rental growth
circa 2% the implied return would be 6% (5%+2%-1%)

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Capitalisation Rates have gradually followed bond yields down

Australian Capitalisation Rates and Bond Yields

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Retail Office Industrial Bonds
12

10

0
Jun 94 Jun 96 Jun 98 Jun 00 Jun 02 Jun 04 Jun 06 Jun 08 Jun 10 Jun 12 Jun 14 Jun 16 Jun 18

Source: The Property Council - MSCI

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Capitalisation Rates (2)
• Since the GFC the growth outlook initially dimmed and risk
premiums increased
• Hence although bond yields fell, capitalisation rates were
slow to follow
• In a portfolio of properties, valuations are reviewed on a
staggered basis so only a fraction of properties (say a third
to a half) are revalued every quarter
• This considerably smooths the volatility of reported returns
which is attractive to DC superannuation funds

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Property Returns are not independent through time
Australian Quarterly Property Returns
1971-2018
8%

6%

4%

2%

0%

-2%

-4%
06 71 06 76 06 81 06 86 06 91 06 96 06 01 06 06 06 11 06 16 06 21

Source: MSCI, Carter (1990)

Quarterly autocorrelation is 0.85

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Direct property returns are different to equities
• Smoothed volatility because of staggered valuations also
suppresses measured covariance
• In mean-variance portfolio optimisation, the distorted risk
characteristics of direct property will often drive excessive
allocations unless constrained
• Property returns are also strongly autocorrelated in the
short-term because of staggered valuations. If
capitalisation rates change, portfolio valuations are
impacted gradually.
• This means annualised volatility calculated from quarterly
returns for example can be significantly understated. From
1972-2018 annual volatility is 6.2%, but annualised
quarterly volatility is 3.3%!
• Even annual return autocorrelation is still 0.65!

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Historical performance has favoured retail property
Cumulative Performance Australian Commercial
Property
10000

Retail
Industrial
All
Office

1000

100
Dec-1984 Dec-1989 Dec-1994 Dec-1999 Dec-2004 Dec-2009 Dec-2014 Dec-2019 Dec-2024

Source: The Property Council - MSCI

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Property and the Credit Cycle
Rolling 12 month Business Credit Growth
40%

35%

30%

25%

20%

15%

10%

5%

0%

-5%

-10%

-15%
Dec-1985 Dec-1990 Dec-1995 Dec-2000 Dec-2005 Dec-2010 Dec-2015

Source: RBA

Spikes in business credit have preceded property collapses,

which coincide with credit contraction

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Variation by Sector
Property Returns in Bad Years
15%

10%

5%

0%

-5%

-10%

-15%
Jun 91 Jun 92 Jun 93 Jun 09

Retail Office Industrial All

Office Property has historically fared worst in downturns due to

excesses of supply/demand imbalance

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 Observations on historical performance
• The property slump of the early 1990s followed a building
boom in commercial property (cranes throughout the CBD)
• The construction boom was supported by easy lending by
banks (30%pa growth in business lending)
• Easy credit also supports business expansion and tenancy
demand, but supply ultimately exceeds demand
• The commercial market suffered from oversupply for several
years, collapsing rents and property values
• The lesson is that acceleration in supply of new space,
usually coincident with easy credit conditions, increases risk
• This is a slow moving phenomenon
• It may contaminate the economy more widely than property

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Some similarity to an indexed bond
• The income stream is a perpetuity
• The natural growth in property rental is broadly in line with
inflation
• However ebb and flow of new property development can
disrupt capital values and rental growth
• Retailing may also be subject to structural change

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Retail property rental growth increasingly
affected by online shopping

Source: Morgan Stanley Research, ABS

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 Alternative approaches to institutional property
investment (1)

Direct Ownership
• will restrict diversification unless the institution is very large
• full control on prices payed and received for individual
properties
• significant management overhead
• can the institution attract appropriately experienced
people?
• An institutional superannuation fund cannot directly
leverage property investment

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 Alternative approaches to institutional property
investment (2)

Unlisted pooled vehicles

• retain the advantage of smoothed property volatility via the
staggered valuation process
• better diversification than direct ownership
• infrequent capital raisings and redemption windows – can’t
add to or redeem as you wish
• management is usually external to the fund – who are they
looking after?
• The vehicle may or may not be leveraged

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Alternative approaches to institutional property
investment (3)

A-REITS
• pooled vehicles listed on the ASX, also know as Australian
Real Estate Investment Trusts (A-REITS)
• better liquidity than unlisted pools but returns are much
more volatile because the market ‘values’ constantly
• Management may be internal or external
• Other things being equal, internal management is attractive
as management is then provided at cost
• A-REITS are usually leveraged

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 Property trusts and leverage
• Property trusts (REITS) are typically leveraged with a debt to
total assets currently around 30%.
• This leverage changes the income and growth characteristics
of the investment compared to the underlying property.
• Let leverage L = Debt/Assets
y = cost of debt
r = net rental yield on underlying property
g = expected growth in net rental income
v = return volatility of the ungeared REIT
• The income yield of the REIT = (r – yL)/(1-L)
• The growth in income of the REIT = gr/(r-Ly)
• The volatility of REIT return = v/(1-L)

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 Property trusts and leverage (2)
Example
• Assume net rental yield of 6%, cost of debt of 5.5%,
underlying rental growth of 2%, unleveraged volatility of 7%,
and leverage of 30%
• The leveraged yield of the trust = (6%-0.3x5.5%)/(1-0.3) =
6.2%
• The leveraged growth = 2%x6%/(6%-0.3x5.5%)= 2.76%
• The leveraged volatility = 7%/(1-0.3) = 10%

The important point is that the underlying asset has been

transformed by leverage. Income and expected growth are
higher, but so is return volatility.

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Property gearing varies by fund type

Source: MSCI, Morgan Stanley Research

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Property – key considerations

Regardless of vehicle (direct, unlisted or listed pool) the

characteristics of the property portfolio will depend on

• Diversification by type and location

• The management arrangements

• The inclusion of development activity

• The degree of leverage (if any)

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Alternative assets – infrastructure, private
equity and hedge funds
• Conventional asset classes (equity, fixed interest, and
property) are defined by a commonality of risk and return
drivers
• The alternative asset basket is for ‘leftovers’ – assets which
aren’t like equity, fixed interest or property
• Although these other assets are grouped, they are not like
each other – fail asset class homogeneity criteria
• The Yale endowment model pioneered significant allocations
to alternative assets but their success has not been easy to
emulate

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Alternative assets – infrastructure, private
equity and hedge funds

Source: Chambers and Dimson (2015) ‘The British Origins of the US Endowment Model’ FAJ Vol 71

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Alternative assets – infrastructure, private
equity and hedge funds

Future Fund Asset Allocation June 2015

Australian Equities
8%
Cash
15%

Alternatives inc
Hedge Funds Overseas Equities
14% 30%

Debt
10%

Private
Equity
Infrastructure 10% Property
7% 6%

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 Alternative assets – infrastructure, private
equity and hedge funds

• Liquidity – often restricted or conditional

• Fees – high and not always fully disclosed
• Leverage – the attractive stability of an infrastructure asset
can be transformed via a leveraged equity position
• Performance measurement – valuation is often appraisal
based and staggered so measures of volatility are
meaningless; serial dependence of returns
• Not well represented by indices – high idiosyncratic risk

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Private equity (1)
• This refers to equity investment in unlisted firms
• Superannuation funds place money with private equity
managers (general partners) who take majority (usually
complete) ownership positions in companies
• The investing funds (limited partners) participate in a finite
capital raising. The investments are made over a period of
time and gradually sold, sometimes via IPO
• Commitments from limited partners are drawn down as
required
• Fee levels (including performance – ‘carried interest’) are
high, and often not fully disclosed under agreements

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Private equity (2)
• Most private equity acquisitions are highly leveraged
• This amplifies expected returns, potential fees, and risks
• Long-term investors are attracted to private equity because
it allows them to earn the liquidity premium
• In valuation, small companies are generally valued with a
higher cost of equity (eg +5%) and there is further
adjustment for high leverage
• So private equity investments are expected to outperform
public equity investments – this is no miracle of active
management

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Private equity (3)
• Harris, Jenkinson and Kaplan (2014) surveyed 1,400
private equity buyout and venture capital funds
• They observed outperformance relative to public market
equivalents (eg SP500) of circa 3%pa, but did not adjust for
higher leverage
• Private equity performance varies significantly by vintage
year (in which funds are committed)
• Performance is lower for vintage years with higher raisings
• There is evidence of strong performance persistence with
private equity managers

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Hedge Fund Strategies (1)
• Convertible Arbitrage – buy convertible bonds and short
underlying equity to access mispricing, maintaining delta
neutrality
• Long/short equity– may be long biased, market neutral or
short biased
• Event Driven Distressed – invest across the capital
structure of companies close to bankruptcy. Exploiting
forced sale by institutional investors. Bankruptcy process
may provide exit strategy

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Hedge Fund Strategies (2)
• Event Driven Risk Arbitrage – capture the spread in merger
or acquisition transactions post announcement (eg buy
target and wait for price to approach bid level)
• Fixed Income Arbitrage – trading anomalies in the yields of
similar securities or baskets of securities
• Global macro – aggressive tactical asset allocation across
global bonds, equities and currencies sometimes involving
leverage

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The Myth of the Absolute-Return Investor

• Promoted on the fantasy that skill will avoid market

exposure when markets fall – beta timing
• Investors want to believe this is possible – like weight-loss
pills advertised in Sunday papers
• ALL investment is a mix of beta exposure, beta-timing
(sometimes) and alpha (which can be negative)
• Terms like ‘absolute-return’ confuse what is happening with
alpha and beta, making performance difficult to interpret
• Absolute-return investors are differentiated by attitude and
fees, not investment acumen

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Long/Short Equity (1)
• The manager usually enters into a securities lending
agreement with a prime broker or custody bank
• To short a stock the manager borrows the stock from the
prime broker and sells it, pledging collateral of either cash
or securities. Collateral will exceed the value of the stock
borrowed. The stock is returned when the manager buys
back to close the position, hopefully after price declines
• A long/short fund will consist of long positions in stocks the
manager expects to outperform, short positions in stocks
expected to outperform and cash.
• For example for every $100 of a market neutral fund there
could be $75 of long equity positions, $75 dollars of short
equity positions and $100 cash.

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Long/Short Equity (2)
• A standard variant is a 130/30 fund where per $100 the
manager is long $130 and short $30. This will have a
market exposure of $100 rather than being market neutral.
• Compared to long only investment, a 130/30 fund benefits
from relaxation of a constraint and so the transfer of skill to
performance should in theory be better
• In practice the investment process behind buy decisions is
not always as effective for shorting stocks. For example
although cheap stocks might appreciate over time, does
that mean expensive stocks decline just as reliably?
• What is more certain about long/short investment is that
management fees are higher

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 Hedge Fund Performance

Source: Hedge Fund Research

• Hedge Funds did well in the bear market of early 2000s but suffered during GFC
• This spoiled their absolute return perception as they demonstrated a market beta
• Note the HRFX index is investible – not all hedge fund indices are

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Hedge Fund Fees
• The typical structure is a base (say 1.5-2.0%pa) and a
performance fee (say 15-20% of performance, sometimes
subject to a hurdle like the cash rate)
• A high water mark will carry forward any underperformance
so that the manager is not simply rewarded for volatility
• Hedge fund managers can sidestep the discipline of high
water marks by closing funds to new business and opening
new funds.
• The aggregate fees (base and performance) are generally
excessive relative to the outperformance generated.
• For example a 130/30 manager outperforming by 4% could
claim fees of 2.8% (2% base plus 20% performance)

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Hedge Fund Replication
• Studies suggest that despite claims of ‘alpha hunting’ the
hedge fund industry is largely ‘beta grazing’.
• If hedge funds are simply creating factor exposures (eg to
equity markets, corporate bond spreads etc) these might
be passively mimiced at much lower fees.
• A factor profile of a hedge fund composite index may
facilitate cheap replication, but are those factors well
rewarded?

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Hedge Fund Transparency
• Hedge funds have long argued that keeping their strategies
and portfolios hidden, even from investors, was key to
competitive performance
• For some funds exposing large illiquid positions, especially
on the short side, could be problematic
• Recent research (Aggarwal and Jorion, 2012, FAJ) has
shown that in fact transparent hedge funds perform better
• Opaque portfolios complicate risk measurement
• No justification for institutional funds accepting lack of
transparency

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Hedge Funds in portfolio construction
• As an asset class, hedge funds are awkward to
characterise in terms of risk and return
• Hedge Fund Indices are often not replicable, vary widely
depending on which funds they include, and are prone to
several important biases (selection and survivorship)
• Modelling an allocation to hedge funds based on the
performance of a hedge fund index is not a good idea.
• A fund allocating to hedge funds typically takes on a
concentrated exposure to a few managers or funds of
funds
• A skeptical view is that hedge funds are an expensive blind
bet on active management skill.

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Thank you for your attention

Greg Vaughan

School of Risk and Actuarial Studies

University of New South Wales

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