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Over geared and over here

Created:
5 August 2008
Written by:
Algy Hall

One feature of the slew of overseas property fund floats that deluged Aim from early 2005 through to the end of last year was the massive levels of gearing (net debt as a percentage of net assets) that many aimed to employ. And this could now become a very pertinent issue, as European property markets start to get the jitters.

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High gearing seemed like a good idea at the time. Overseas funds answered the call for higher yields by raising debt at a lower cost than the rental yield available on property purchases, which in turn boosted the income available to shareholders from rents.

Companies in this sector have tended to talk about loan-to-value (LTV) ratios rather than the more widely used and understood gearing measure. A cynic would say this is because some of the LTV limits in the sector, when expressed as gearing, look high compared with conventional UK-listed property companies. Indeed, according to a fairly comprehensive sector research regularly produced by Oriel Securities, the median permitted LTV ratio in the sector is 75 per cent, which is equivalent a whopping 300 per cent gearing level. What's more, when markets were strong, many companies saw these limits more as targets than maximums, although current market conditions have changed many funds' - and lenders' - moods.

High gearing may seem all well and good when rents look secure and property prices are stableas they were when these vehicles were swarming onto the market. Back then, gearing supercharged the impact of property price rises on NAV growth. However, as the Investors Chronicle has pointed out in the past, there is a gnarly downside to gearing when property prices fall, because it magnifies the performance on the way down too. And having a large amount of interest to pay on bank debt also means the risk associated with tenants not paying their rent increases. So, rather than being a virtue, high gearing could now mean serious trouble if European commercial property markets follow the UK’s recent trajectory.

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