Maarten van der Spek: Real estate return requirement is complicated but essential

February 20, 2024

By Maarten van der Spek, Spek Advisory

Real estate often is an easy target for politicians to score points with the general public. This is also the case now, with the return requirement. However, implementing effective policy for this purpose appears to be complex.

To keep the housing market affordable, politicians called on housing investors to settle for lower returns. But a lower return requirement does not solve the problem. Moreover, the ultimate investors, for example retirees, are not helped by a lower return. For a real solution, politicians must tackle the structural shortage of housing, but of course you cannot score with that in the short term.

Determining a return requirement for private real estate also sounds simple. However, the implementation is much more complex if you want to do it right. A return requirement is an essential tool for determining whether a new investment is worth the risk and must have the following three fundamental properties:

1. It must be linked to the current capital market.
2. It must be connected to the asset allocation.
3. It should reflect all investment risks involved.

The processing of these properties may differ slightly per investor, but the principle is always the same. The starting point for a return requirement is the market interest rate. If interest rates rise, it is only logical to increase the required return, since the risk-free alternative, the government bond, will also generate a higher return.

It is interesting that, with the current high interest rates, some models generate a return requirement that is higher than the current expected returns. Such an investment climate also existed in the mid-1980s, a period with very high inflation and high interest rates, and in the years surrounding the financial crisis (2005-2008), a period in which real estate was overvalued due to the use of too much financing.

Such a period is difficult for managers who have capital available to invest. It requires understanding for investors who currently have other, better-returning options, given the risk. It is therefore extremely shortsighted to say that institutional investors should settle for lower returns, while they bear all the risk and also have a responsibility to their supporters.

The second fundamental characteristic is the link between the return requirement and the strategic allocation. For example, if a long-term real estate return of 6% is assumed, while the risk-free return is 4%, then the average real estate risk premium is 2%. This premium reflects the additional return that an average real estate investment must deliver compared to the risk-free return. Because of this link, every new investment will make a positive contribution to the strategic allocation.

Finally, it is crucial to translate all specific investment risks into an increase or decrease in the risk premium. As you take on more or less risk compared to your benchmark, it is important to increase or decrease your required return. The investment risks included include country and sector risk, leverage, style, development risk, investment horizon and currency. All these factors should be included in a return requirement.

Just as politicians easily score points with simplistic proposals, reality underlines the need for a well-thought-out approach that takes into account the complex interplay of factors that influence the market. Drawing up a return requirement is also much more complex than many people think and experience shows that this is often not sufficiently taken into account in the investment process.

Spek Advisory is an independent consultancy firm that focuses on helping investors and managers optimize the strategy of the private investment portfolio, with the aim of improving the risk-return profile.

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