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Boom or pop - the debt effect

Created:
25 June 2007
Written by:
Algy Hall

This is a very simplified illustration of the impact debt can have on returns, using the example of the 'Sizzling Hot Property fund'.

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Imagine the fund raised E100m by selling shares on Aim and used a loan-to-value (LTV) ratio of 80 per cent (400 per cent gearing) to build a E500m property portfolio in some sizzling hot property market. It pays 5 per cent interest on its borrowings and its other expenses are equivalent to 3 per cent of gross assets, which is all paid out of rental income. But it has invested in properties that generate a lofty rental yield of 10 per cent.

So it is generating E50m of rent each year, of which E20m is spent on interest and E15m goes on other expenses. That means shareholders' initial E100m is generating them E15m of income a year – fantastic!

In this hypothetical boom scenario, property values rise by 20 per cent a year from the fund's buying price and rents go up by the same amount. So, a year on, the portfolio is worth E600m, and E400m of this is still debt, but shareholders have doubled the value of their E100m investment - open the champagne! What's more, the Sizzling Hot Property fund's rent roll has risen to E60m while interest costs have stayed put and other expenses have edged up to E18m. That leaves E22m worth of income for shareholders being generated from the original E100m of equity – I foresee a dividend bonanza.

But things could go the wrong way for the Sizzling Hot Property fund. What if property values fell 20 per cent from the original buying price and rents fell by the same amount? In this scenario, the Sizzling Hot Property fund's portfolio would now be worth E400m, the same as its debts, and shareholders would be left with none of the E100m originally invested - NAV has gone pop! As for income, assuming the fund's banking covenants are not broken, the property portfolio is now generating E40m against E20m of financing costs and E12m of other expenses. So income has almost halved to E8m – what a disappointment!

This article is to be read in conjunction with Aim's property funds.

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