Financial Innovation in Property Markets

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					   Financial Innovation in
        Property Markets

     Implications for the City of London

The Corporation of London in association
     with the RICS Research Foundation

  Authors: Colin Lizieri, Charles Ward and Stephen Lee
                                    Reading University

Introduction                                           1-3

The Traditional Model: Review & Critique               4-13

Innovation & Continuity: New Products & Claims         14-31

Creating Value Through Innovative Financial Products   32-41

A Formal Evaluation of Innovative Products             42-51

Conclusion                                             52-55

Acknowledgements                                       56

Bibliography                                           57-60


It has been suggested that the UK property market has lagged behind North America
in adopting innovative analytic models and financial vehicles. In the property market
boom in the mid to late 1980s, innovative development finance and funding
techniques were adopted in UK property markets (and, in particular, to finance office
development in central London). The subsequent property market slump and
general recession led to retrenchment, with more traditional techniques and
valuation models dominating the market. This has been seen as a constraint on
developers, landlords and occupiers, particularly in the light of the demand for more
flexible business practices and the intense competition between countries and cites
for market share.

Over the last few years there has been growing evidence of more innovative
approaches in property markets. Debt securitisation and asset-backed securitisation
has become more common, the £1.5bn Broadgate securitisation providing one
obvious, major example. The Private Finance Initiative has led to consideration of
innovative funding techniques and new ways of procuring space and services. The
domination of the long UK institutional lease has been eroded, while new forms of
supply - the rise of the serviced office sub-sector, for example - and new forms of
paying for space have evolved, such as the consideration of entry fees at Bluewater
and turnover rents elsewhere as a complement or alternative to traditional retail
rents. There has been an active debate on the creation of securitised investment
vehicles, despite Treasury reluctance to countenance tax transparency, and much
interest in derivatives, notably swaps, and option pricing techniques.

Nonetheless, as research by the University of Reading and others has demonstrated,
there is much resistance to innovation within the property industry. Research on the
valuation of serviced offices, for example, reveals that traditional valuation
techniques remain dominant and that those techniques act as a constraint to supply.
In particular, loan valuations, based on vacant possession value, discount the
potential additional income from the business. Similarly, research strongly suggests
that traditional valuation methodology understates the investment worth of shorter
or non-standard leases when compared to simulation-based cashflows or option
pricing models. Since asset valuation is fundamental to the development of active
securitised debt and derivative markets, this presents a constraint to innovation.

This report presents findings drawn from a research project commissioned by the
Corporation of London. The broad aim of the project was to analyse the potential for,
and the impact of, innovations in the financing, funding and procurement of
property and to spread knowledge of innovative techniques to relevant parties with
interests in the City of London.

Specific objectives arising from that aim were to:

   •     critically review existing models of finance, funding and appraisal in the property
       industry in the light of changing business requirements;
   •     survey recent innovative financial products, vehicles and funding techniques in
       commercial property markets;
   •     examine case studies of innovative finance and procurement methods to illustrate the
       potential (and pitfalls) of the new techniques;
   •     draw lessons from developments in the US commercial real estate markets;
   •     consider likely future trends in the real estate market and assess the interaction
       between innovation and public policy.

The research involved an intensive literature search covering academic and
professional publications; collection of material relating to specific schemes and
projects; and a series of semi-structured interviews with market participants in
London and in New York. Those interviewed included staff from investment banks,
rating agencies, corporations, institutional investors, property companies, and
property consultants and agents. The New York interviews were arranged in
conjunction with New York University, and we are pleased to acknowledge their
important contribution to the project. These structured interviews were augmented
by a series of informal discussions with market participants. We were also able to
draw upon unpublished research material from colleagues at the University of
Reading and from the wider property research community.

The original intention had been to conduct three detailed case studies of innovative
deals. As the research progressed, it became clear that this was not an appropriate
strategy. First, most schemes were sufficiently new that confidentiality and
competitive issues limited access to data and information. The detailed information
necessary for a full financial appraisal was not available. Second, most schemes seek
to take advantage of the particular circumstances of one or more firms, the specific
properties involved and the contingent market conditions applying at that time. As a
result, it would be difficult to draw general conclusions from any one scheme.

It was thus decided that a more productive approach would be to review the types of
schemes being undertaken, to assess their advantages and disadvantages and, in
general, to provide a formal framework for evaluating new products. In particular,
we sought to identify the sources of added value. What problems did the new
product address? How successful was the new product at overcoming inflexibility
and inefficiency in the market? Were there any hidden costs resulting from the new
product? These questions shaped our analysis.

In the next chapter, we examine the structure of the UK property market and the
traditional model of financing and funding the supply of space. It is suggested that
the traditional system creates inflexibility which both hampers the efficient supply of
space appropriate to business needs and contributes to the pronounced cyclicality of
the property market. Chapter three reviews the attempts to introduce flexibility and

innovation into the market. While we focus on recent UK initiatives, we point to
earlier deals that suggest that there are antecedents for the changes seen since the
mid 1990s. We also examine the US market to see what lessons can be drawn from
there. Major claims have been made (particularly in the property press) about the
advantages of the new schemes. In chapter four, we provide a theoretical framework
that can be used to evaluate the advantages and disadvantages of new initiatives.
This framework is used in the fifth chapter to examine some of the types of schemes
reviewed earlier. It is suggested that some benefits are bought at the expense of costs
and inflexibility elsewhere in the system; that some benefits result from a particular
combination of market circumstances that is unlikely to be sustained in the future;
but that some benefits result from the elimination of market inefficiencies and the
closer integration of property and the other capital markets. Finally, we draw
conclusions and point to possible future trends.


In this chapter, we review traditional models of the finance, funding and
procurement of commercial real estate, highlighting aspects of the models that may
lead to inflexibility or mispricing. In so doing, we emphasise the normal or dominant
practices that have developed in the United Kingdom. To an extent this is a
caricature: commercial practice does not conform to such simple models, the market
is complex, and there have always been variations around the standard form.
Nonetheless, standardisation is a striking feature of the UK (prime) property market;
institutional structures and, in particular, valuation practice helps preserve that
standardisation. As we show later, many of the innovative securitisation schemes
proposed or implemented actually rely on elements of the standard model. Although
they are closely linked, we start with the financing and funding of real estate, and
then consider the procurement of space by businesses and the structure of the
corporate real estate portfolio.

Property Finance and Funding

In the conventional model, property companies finance development from their own
equity or through short term borrowing. They then seek longer term funding in
order to retain the completed development or sell the property for profit – the take-
out involving institutional investors, other property companies, sale for owner-
occupation or, increasingly, sale to overseas investors.
Traditionally, short-term finance for development has been provided by banks or
institutions in the form of a loan or overdraft facility, with interest rolled up to the
end of the loan or project development period (a bullet loan). Until the 1980s, the
term of the loan usually coincided with the length of the construction period.
Thereafter, loans might run to the first rent review on the assumption that
refinancing or take-out will be easier at that point. In the second half of the 1980s,
banks competed actively to provide capital for (often speculative) development and
property companies were able to obtain finance via tender panels, where an
underwriter would assemble a panel of banks who would compete for the
opportunity to lend, driving down interest rates, syndicated loans and multiple
option facilities, where the company could tap different sources of finance and
different lenders up to agreed limits. In the 1990s, following the property downturn,
lending became more constrained and conservative, as it had in the post-crash mid

Loans might be secured on the company or on a specific project. Security in the form
of a fixed charge on the development was standard until the 1986 Insolvency Act.
Following the Act, an appointed administrator could frustrate the exercise of the
fixed charge. Lenders thus sought fixed and floating charges or off-balance sheet
financing solutions to protect their interests. Interest rate policy, too, has varied over
time, with fixed rates being superseded by floating rates based on LIBOR or CD rates

in the 1970s and 1980s, with more variety in the 1990s as inflationary concerns

In assessing the security provided by the property assets or the company, banks have
taken a relatively conservative position. Low loan-to-value ratios, valuation of
property at vacant possession, or consideration of the liquidation value of the firm -
the “gone” rather than the “going” concern basis - have been normal, except in
competitive “hot” lending markets where the lending imperative dominates
prudence. In more constrained times, short-term finance has depended on a forward
commitment for funding or sale, or on the scheme being pre-let to a good covenant

To pay off short-term project lending, the completed development would either be
sold or, if a long-term interest were to be retained, funding sought in the form of a
mortgage. The traditional mortgage loan was fixed rate with a long term, with a
charge on the building(s) funded. The lender obtained a favourable margin over the
redemption yield of a comparable maturity Gilt, typically 175-225bp (basis points),
and had both the security of a conservative loan to value ratio and a positive interest
coverage ratio. The property company hoped to make a geared profit as the rental
and capital value rose relative to the fixed cost of lending.

In addition to a single loan from a lender or syndicate of lenders, property
companies raised capital by issuing mortgage debentures - tradable debt instruments
with a fixed and/or floating charge on specified properties. The spread over
comparable gilts has varied considerably from as little as 50bp in the mid-1990s to
over 225bp in 1989/1990. Debentures may be privately placed, listed on the domestic
market, or offered in the Eurobond markets.

Other forms of long term funding have been less common. Profit sharing mortgages,
participating or convertible, are comparatively rare in the UK although widespread
in the US. Profit sharing mortgages tend to have lower interest rates and to unlock
more capital for the borrower and, hence, are more prevalent in weak markets. The
lender gains a higher yield provided that the projected growth occurs but carries a
higher risk. There are legal issues (the “clog on the equity of redemption”), and tax
and regulatory issues - are they collective investment schemes under the FSA? - that
need to be overcome. Similarly, finance leasing has not been common in the UK,
certainly by comparison to mainland Europe (the real estate leasing market in
Germany is some seven times larger than that in the UK). There are tax advantages,
although the accounting benefits have been reduced by the need to show liabilities
on balance sheet.

Sale and leaseback schemes, where the property company sells the completed
development to an institution and takes a long-term lease, exist. The developer hopes
to obtain a profit rent from sub-letting. The risk and profit-sharing structure varies,
from a fixed or defined sum, akin to a ground rent or development lease, to an
agreed apportioning of any rental uplift.

The cost of borrowing depends upon the debt instrument and the credit rating of the
company. The latter, in turn, depends on the asset values of properties held and the
track record of the firm. For property-specific lending, banks typically assess value
on a vacant possession basis and specify a loan-to-value ratio of less than unity. This
reflects both uncertainty as to the valuation and the assessed risk of the sector:
commercial property lending carries a full risk weighting under the Basle Accord on
capital adequacy, although banks in certain European countries, notably Germany,
may half-weight loans. One major risk is the large lot size of most commercial real
estate assets, which, alongside property’s heterogeneity, exposes the bank to high
levels of specific risk. Some diversification may be obtained by loan syndication,
which additionally shares the due diligence and monitoring costs: it has been
suggested that, in the late 1980s, loan syndication reduced the amount of risk analysis
as all parties assumed that the other participants had conducted a full loan appraisal
and hence were less careful. Large lot sizes create market barriers, with smaller
investors unable to gain exposure to the real estate debt market without taking
undue, unrewarded risk. The gap between the primary loan and the desired level of
gearing must be met by expensive mezzanine finance.

Such apparent caution in lending has not led to a stable flow of funds into real estate.
The pattern of bank lending to the property sector is strongly cyclical. At times of
competitive pressure amongst banks, margins are reduced and loan-to-value ratios
raised, often to close to 100% on valuations which may prove to be inflated. Since
such lending tends to coincide with the cyclical peak of capital values, this has led to
suggestions that it is bank lending that fuels real estate’s boom and bust pattern. This
is unproven: both cycles are, for example, strongly associated with, and follow,
movements in interest rates. Lending at the peak does, however, call into question
the effectiveness of due diligence procedures in the face of strong competitive

At the other extreme of the cycle, banks, with the legacy and recent memory of non-
performing property loan portfolios, may be reluctant to lend to the real estate sector
at all and set onerous conditions, leading to a “credit crunch1 ”. In a credit crunch,
banks initiate policies to reduce the weighting of their property loan book and refuse
to make new loans. This results in viable, profitable schemes failing to obtain finance,
with associated welfare loss, a common complaint from the industry in the mid-
1990s. In part, this implies that the property lending market is segmented and not
fully integrated with the capital markets in general, with borrowers unable to tap
into the full range of sources of capital. This segmentation means that property
lenders carry high specific risk levels through holding undiversified loan portfolios,

1   On the US “capital crunch” see Fergus & Goodman (1994), Hancock & Wilcox (1993), Peek &
Rosengren (1994), Weber & Devaney (1998). Hendershott & Kane (1992) discuss the role of
bank lending in over supply. Higgins& Osler (1997) examine the adverse impact of bank
lending on real assets in a number of OECD countries – a topic also considered by BIS (1994)
and the IMP (1993).

and charge borrowers higher risk premia, a situation which results in an uneven flow
of funds not necessarily related to the utility of the schemes under consideration.

Property companies and developers have other sources of capital, of course. In
common with other firms, they may issue bonds and commercial paper. Few if any
property companies are able to issue unsecured debt that would obtain the highest
credit ratings2 . This reflects concern about the true underlying asset values and about
the cyclical nature of the real estate market.

Property companies can also seek capital from the stock market through an initial
listing, a rights issue or a stock split. The traditional view has been that property
investment companies are valued on a discounted net asset value basis. However,
property companies trade at a substantial discount to net asset value, averaging 25%
in the long run3 . There are many explanations for this discount: contingent capital
gains tax liability, valuation uncertainty, hidden management costs, illiquidity 4 . The
net effect is as if the stock market imposes a loan-to-value ratio similar to that
applied to debt. In the late 1990s and into 2000, the property sector under-performed
the overall stock market, leading to adverse comments from analysts about
management expertise and added value in the sector. In part, the poor performance
reflected the downgrading of value stocks relative to growth stocks, and the general
decoupling of such sectors from the whole market - property is not unique in this
respect - and the sector has recovered somewhat. Nonetheless, the large discounts to
NAV led to a number of companies delisting, notably MEPC (market capitalisation
of nearly £2billion), with many others buying back stock and increasing their private
element (see Table 1). The difficulties in the listed sector are compounded by its
small size: it accounts for barely 2% of total market capitalisation with only two FTSE
100 companies (Land Securities and Canary Wharf) and numerous small
capitalisation stocks. Recently a number of property companies were ejected from
FTSE indices due to lack of trading. This has had an adverse effect on stock prices as
index tracking funds are forced to sell their shares in these companies.

2   Moody’s rated Land Securities’ senior unsecured debt at A1 and Hammerson and MEPC at
Baa1 at end 1999, Standard and Poors give long term corporate ratings of BBB+ to Capital
Shopping Centres and MEPC, for example.
3   Barkham & Ward (1999).
4   Discussions may be found in Barkham & Purdy (1992), Adams & Venmore-Rowland (1990).

Table 1: Property Sector Bids, 1999-2000

       Firm                Equity Value       Discount to NAV        Comments
       MEPC                   1,924                  44.8%           Hermes/GE/MBO
       Burford                  498                  47.6%           MBO / Lehmans
       Wates                    373                  37.8%           Pillar / CLOUT
       Frogmore                 293                  33.4%           MBO / Trefick / RBoS
       Greycoat                 282                  29.5%           Mercury (auction)
       Milner                   169                  48.8%           Delancey
       Evans                    164                  44.2%           Family take private
       Scottish Met             153                  38.0%           Rodamco (hostile)
       Eskmuir                  144                  52.9%           Laing Family
       Chesterfield             139                  63.6%           Quintain
       Allied London            135                  51.8%           JER / MBO
       Hemingway                119                  55.8%           PRICOA / MBO
       Dencora                   58                  46.8%           Knowle Hill
       Raglan                    51                  40.0%           MBO
       Prestbury                                                     Liquidation

Source: adapted from Merrill Lynch (2000)

The picture presented here is stylised and one which over-simplifies the situation.
Financial engineering has a long history in the property industry and there are many
niche products and providers organising finance and funding. Hybrid debt-equity
vehicles exist ranging from conventional convertibles to more innovative equity and
profit sharing loans. Nonetheless, the traditional model of finance and funding still
dominates the market, leading to, arguably, a relatively high cost of debt and equity,
an uneven supply of capital and, overall, a lack of flexibility.

Procurement and Occupation

The institutional form of the UK occupational property market has attracted more
criticism than the finance and funding system. In particular, the dominance, at least
in the market for prime space, of the “institutional lease” with its lengthy term, full
repairing and insuring terms and upward only rent review clauses has been the
subject of much complaint. This has been reviewed extensively elsewhere5 . In a
recent survey for the RICS (Crosby et al. 2001) only 8% of respondents thought that
the UK leasing system was completely satisfactory, while 27% thought that the
system was unsatisfactory and undermined their organisation’s ability to operate

5   See, for example, Crosby et al. (2000, 2001); Lizieri et al. (1997) for reviews and discussion.

To summarise the issues:

      Ø the long lease does not mesh well with the planning cycle of modern
        business, where planning horizons have shortened to three to five years. A
        commitment of fifteen to twenty-five years, with onerous costs and
        conditions for breaking the lease, assigning or sub-letting, appears
        inappropriate and inflexible;
      Ø the remote nature of the lease places a considerable property management
        burden in cost and time on the occupier without any clear benefit from equity
        participation, diverting attention away from core business activities;
      Ø the upward-only rent review clause benefits the landlord in rising markets
        but prevents the tenant from taking advantage of any falls in market prices.
        In an over-rented situation, the tenant is paying more than the economic rent
        and hence business profitability must suffer;
      Ø increasingly, firms separate core and peripheral business activity, and
        workers; their corporate real estate needs are similarly divided. However, the
        market has not supplied the peripheral space required at appropriate cost
        and quality;
      Ø the dominance of the institutional format has been preserved by valuation
        practices that serve to stifle innovation.

This last is important for the argument developed in this report. Valuers have, it is
suggested, marked down sharply the prices of properties let on non-standard terms.
There is evidence that the downward adjustment is not justified in terms of the
additional risk to the cashflow. The net result of this process is that landlords will be
reluctant to let on non-standard terms for fear of damaging asset values. Similarly,
potential purchasers will be unwilling to acquire, and banks will be unwilling to lend
against, space let on non-standard terms. This results, at least in part, from
traditional valuation methods which, predicated on comparative evidence from
similarly leased properties, are ill-suited to estimating the economic impact of
differing cashflow patterns.

This should create arbitrage opportunities. Historically, there is evidence of property
investors exploiting mispriced asset classes – short leaseholds valued using dual rate,
tax-adjusted sinking fund methods or over-rented properties valued using term and
reversion models, for example6 . Two factors mitigate against this. The first is that, to
gain abnormal profits, the new investor must hold the asset to the end of the lease or
rely on the market “catching up”. This is problematic for investors since it restricts
their ability to manage their assets and because their intermediate performance is
measured based on the same valuations that created the arbitrage opportunity7 . The

6   See Baum (1982), Crosby & Goodchild (1992).
7   Formally, a Nash equilibrium holds in the market.

second factor is that the deal must satisfy due diligence procedures, and valuers
advise buyer, seller and lender, helping to preserve the existing price8 .

Counter-arguments include:

      Ø the market will deliver space and lease forms according to demand. In
        practice, most firms do not have wildly fluctuating space needs and the long
        lease provides security of tenure, allowing them to invest in their
        occupational property and amortize those costs;
      Ø landlords would be prepared to provide much more flexible lease terms if
        tenants were prepared to pay for the additional risk imposed upon the
        landlord. Again in practice, however, tenants demand flexibility and
        “market” rents that assume the stability of the institutional lease form;
      Ø the upward-only rent review is not as onerous as assumed, since market rents
        tend to rise, if only due to inflation, above the (passing) rent at the last
        review. The 1990s property downturn was unusual in creating over-rented
        properties. The rent set also assumes the upward-only review clause and
        would be higher if upward and downward reviews prevailed;
      Ø an upward-only rent review is a signal: tenants will accept one if they believe
        it will be of little cost: that is, that the business environment and rents will
        rise to the next review. To grant an upward and downward review is
        therefore a pessimistic signal to the markets. We return to this signalling
        argument below;
      Ø the institutional lease has created a favourable investment environment,
        ensured that funds flow into real estate and, hence, created and preserved a
        healthy rental market.

This last point is somewhat contentious. The contrast is typically drawn with
mainland Europe, where far higher levels of owner-occupation prevail. However, the
US has developed a rental market that is, at the least, no less developed than that of
the UK with reviews to the prevailing market rent and much shorter (five or ten
year) leases.

That there is a demand for more flexible occupational forms can be seen from the
early 1990s when over-supply in the market placed potential tenants in a stronger
than usual position over landlords. The result was a shortening of average lease
lengths, a greater variety in lease lengths, and the granting of tenant options to break
the lease. It should be noted that the upward-only review clause seems to have

8   Brown, amongst others, has questioned this, arguing that there are sufficient deals and
    sufficient information that such a process of valuer influence could not be sustained.
    However, the characteristics of property markets mean that no building is a perfect
    substitute and that markets are segmented. It was suggested to us in the course of the
    research that there had only been around eight deals of £200million or more in central
    London in the last four or five years, each with a very restricted pool of potential traders. In
    such thin markets, price anomalies can persist.

remained sacrosanct, and the majority of leases, despite being shorter, continue to
place the responsibility for repairs and insurance on the tenant. There is some
evidence that these gains by tenants have been eroded as vacancy rates have dipped9 .

The rise of the serviced office sector provides further evidence of the demand for
more flexible occupational forms. The apparently high charges on a square footage
basis in part reflect the “whole cost” nature of the space+service package, and in part
scarcity of supply. As with non-standard leases, there is evidence that some valuers
have marked down sharply the values of serviced space and business centres due to
unfamiliarity and perceived stigma effects. This curtails supply of space, restricts
investment and makes it more difficult for serviced office suppliers to raise debt to
fund activity. Serviced offices and other “packaged” solutions to space procurement
are considered further in later sections.

Firms that own a sizeable proportion of their corporate real estate resources face a
number of problems. The asset values of their properties may not be fully reflected in
the market capitalisation of the firm. As with property investment companies, there
appears to be a sizeable discount. A number of major retailers have total property
assets valued in excess of their market capitalisation (which would appear to make
them vulnerable to asset stripping)10 . This may result from uncertainty as to the true
value, concerns about loss in the event of forced sales or belief that the asset
valuations reflect the value of the property as a going concern.

This problem is compounded for firms whose required return is greater than that
generated (notionally) by the property assets. A firm with a required return of 20%
may be damaged by holding real estate assets whose value reflects a yield of, say, 8-
10%. This will be particularly evident to analysts employing a structured technique
such as Economic Value Added but will also be evident in conventional accounting
measures such as Return on Capital Employed. As a result, firms may seek to release
capital locked in real estate and apply the capital to the core business. This should
have the added benefit of improving transparency for shareholders. However, there
is a major cost. Much business lending is secured on the property holdings of the
firm. By divesting itself of real estate, the firm may face higher future borrowing

The conventional route to releasing capital locked in real estate has been through a
sale and leaseback arrangement. While the structure is well understood and has tax
benefits, it does have a number of disadvantages. First, it is often a very expensive
form of borrowing, when the full costs of the rental outgoings are considered over
the life of the lease. Second, most sale and leasebacks have, traditionally, been on
standard institutional lease terms and for the long term, creating inflexibility in the

9   For a comprehensive review of these leasing initiatives see Crosby et al. (2000).
10   Wainwright (2000) provides a table of retailers’ market capitalisations and land and
     property values which shows a number of firms with property to capitalisation ratios in
     excess of one, including major high street chains.

occupational form. Third, there is uncertainty at the end of the lease term, with the
firm forced to seek alternative accommodation, negotiate a new lease or repurchase
the assets. Proposed changes to accounting standards will compound the problem,
since firms will need to record the rental liabilities over the whole life of the lease, as
with financing leases. These factors have driven a search for new ways of utilising
the financial potential of corporate real estate assets.

Overarching these issues are tax considerations. A full discussion of the impact of tax
structures on the UK property market is outwith the scope of this report. However, it
is clear that any appraisal of the advantages and disadvantages of particular debt
and equity vehicles must account for the tax position of a firm or an investor. For
example, UK-listed property companies are subject to double taxation in that
dividends, subject to taxation, are paid from post-tax profits. This is problematic for
tax-exempt institutions holding property company shares, particularly since the
abolition of the ACT concession11 . By contrast, US REITs, provided that they meet
certain qualifying conditions, are tax transparent, rent less costs being passed
untaxed to shareholders. This has led to numerous attempts to obtain Inland
Revenue approval for a tax-transparent UK property investment vehicle. For owned
real estate assets, the issue of depreciation is important, with UK practice, in
particular the absence of a depreciation allowance for the building, differing
markedly from that of the US. Furthermore, there are differences in the treatment of
commercial and industrial property. The tax shield effects of rental and loan interest
payments must be considered in any property-related structured finance scheme.


In general, finance and funding of real estate has been segmented from other parts of
the capital market. This has led to fluctuations in the flow of funds into property,
periodic capital famines and, possibly, higher borrowing costs than justified by the
risk of the sector. In many market environments, conservative lending rules, fuelled
by uncertainties about valuation and the cyclical nature of market performance,
restrict the ability of firms to raise capital, through low loan-to-value ratios, high
interest coverage ratios, and high margins. This may contribute to the property cycle
by restricting supply of space, and denying finance and funding to viable projects. In
turn, this can fuel rental and capital growth, which can then encourage excess
lending and lead to a supply boom.

The interaction of the financing and funding system, the traditional pattern of
ownership and the standard methods used in property valuation have created and
preserved a particular form of property procurement and occupation in the UK, in
the form of the institutional lease. The features of this lease - long term, strong
constraints on surrender and assignment, repairing obligations and upward-only

11   Property company treatment is no different to that of any other listed company here, whose
     income is taxed prior to distribution of dividends. The contrast is with directly held real
     estate assets.

review clauses - make it an onerous form of occupation. However, it is the lack of
variety produced by the UK system that may be the most damaging feature. In a
business environment which emphasises flexibility, where planning horizons are
short and where firms have distinct property requirements for their core and
peripheral areas of activity, a “one size fits all” occupational form is a constraint on
business. Nevertheless, any attempt to introduce more flexible occupational forms
must overcome valuation, financing and funding inertia.



In recent years, a number of new vehicles and products have been introduced to the
UK property market in an attempt to solve some of the problems of the traditional
finance, funding and procurement model discussed in the previous chapter. Some of
these innovations have been specifically tailored to a segment of the UK market,
while others apply techniques utilised in other markets, notably in the United States,
to the UK. In this chapter, we briefly review the innovations and the claims made
about them. We then question whether the last few years do represent a sea change
in property finance, examining the historic antecedents of the “innovations” and
previous attempts to introduce flexibility and liquidity in the UK market. Finally, we
draw parallels and contrasts with developments in the US market.

“New” Products and Vehicles – Issues of Terminology

In examining innovation in the UK property market, an immediate difficulty is how
to delimit the field. As a starting point, we examined the term “securitisation” –
broadly, the creation of tradable paper assets. However, there is no consensus on the
definition and scope of securitisation. Recent activity has focused upon mortgage-,
asset- and income-backed securitisation. Even here, there is confusion. The British
Land securitisation of the rental income of various Broadgate office buildings is
referred to by one of the rating agencies as a mortgage-backed security, in that there
is a charge on the buildings, while another restricts mortgage-backed securitisation
more strictly to bond or paper issues backed by pools of loans, and refers instead to
asset-backed securitisation. A decade ago, the UK property literature used
securitisation to refer to proposed equity vehicles such as Single Property Ownership
Trusts (SPOTs), Single Asset Property Companies (SAPCOs) and Property Income
Certificates (PINCs) which aimed to divide the ownership or beneficial rights of
individual buildings. More recent attention has focussed upon debt instruments.

A further issue is the extent of innovation. Sale and leaseback is a traditional method
by which firms realise capital from their corporate real estate resources. In recent
years, there have been a number of deals (Sainsbury’s “Project Redwing”, the Abbey
National/Mapeley deal) which are more complex in structure. When does a deal
become “innovative” rather than a variation on a traditional theme? Pillar’s
acquisition of the Wates City portfolio involves the creation of an offshore special
purpose vehicle. However, this is structured as a unit trust, modelled on the 1990
Morgan Grenfell offshore PUT, which is not innovative in itself: it is, perhaps, the
combination of unit trust, offshore vehicle and corporate acquisition which is unique.
There has been considerable growth in the use of Limited Partnerships as a tax-
efficient means of sharing ownership and overcoming property’s large lot size
problem. However, the legal structure of Limited Partnerships goes back to 1907.

We have adopted a pragmatic approach to overcome this problem. In examining
deals, transactions and vehicles, we have assessed the extent to which the structure
provides a way of overcoming some of the disadvantages of property as an
investment class and/or the traditional model of finance, funding and procurement,
including those schemes that directly address - or claim to address - the problems. It
is not possible to provide a comprehensive review of all the activity. Rather, the
examples here illustrate developments in the field.

The scope of the project precluded an examination of the full range of new property
procurement solutions and we have therefore confined ourselves to those schemes
directly related to corporate financial structure or capital release. Although the
institutional format lease still dominates the prime end of the UK property market,
new supply solutions have emerged. These range from more flexible lease forms, in
terms of length, options to break and rent setting, via different rent fixing
arrangements - indexation, prescribed annual uplifts, profit sharing arrangements or
even, as with the suggestion for charging customers at Bluewater, no formal rent at
all - through to space and service packages, such as serviced offices, outsourcing of
all real estate while retaining beneficial interests, spin offs. These have been reviewed
elsewhere12 , although most reviews do not pay full attention to the implications for
corporate finance and company value. We address this issue in outline below. Nor
have we considered moves in the quoted property company sector to delist,
restructure or go private except where this has been accompanied by the use of a
structured finance solution or issuance of securities.

Securitisation: CMBS, Asset-Backed and Income-Backed Structures

In a real estate mortgage or asset-backed securitisation, an issuer, usually a special
purpose vehicle created specifically for the purpose, offers bonds or commercial
paper to the capital markets or for private placement. The coupon and capital
redemption payments come from income from an asset or pool of assets - rental
income or loan repayments - and security against default or delinquency is provided
by some charge over the assets such as a first mortgage on the property. A
commercial mortgage-backed securitisation, sensu strictu, entails the offering of
securities whose cashflow derives from repayments made on a commercial real
estate loan or, more usually, from a pool of loans. The term has been applied more
broadly to include issues where the securities’ cashflow derives more directly from
the rents of property assets with the title held in trust as security for the loan or there
being a first charge on the properties. These might also be described as asset- or
income-backed securitisation. The commercial mortgage-backed securities market
evolved in the United States, modelled on the success of residential mortgage-backed
securities, with the asset-backed market following in the late 1980s.

The cited advantages of securitising a pool of commercial property loans include,
from the lender’s perspective, the following:

12   See, for example, Crosby et al. op cit., Gibson & Lizieri (1999) and the bibliographies therein.

   Ø a reduction of the lender’s exposure to specific risk in the form of large single
     loans or to the property sector concerned;
   Ø borrowing taken off balance sheet, thus improving capital adequacy and
     solvency ratios;
   Ø tapping of a new source of capital from a wider pool of investors, particularly
     valuable if conventional sources are constrained;
   Ø profits from arrangement and service fees, and from the spread between the
     loan interest and that payable on the bonds or commercial paper;
   Ø the flexibility to structure the securitisation to match liabilities, to adjust
     duration and, in general, to manage assets.

These advantages have to be set against costs: the arrangement and underwriting
costs, rating costs, credit enhancement, insurance guarantees and any requirement to
over-collateralise or ring-fence proceeds as additional security.

For investors, claimed advantages include:

   Ø the ability to gain exposure to a market that would otherwise be subject to
     entry barriers, primarily due to high entry costs;
   Ø the ability to acquire assets that are marketable and liquid;
   Ø improved capacity to tailor and actively manage investment portfolios;
   Ø the ability to invest in returns from a diversified pool of loans, avoiding
     specific risk problems;
   Ø low transactions, management and monitoring costs, particularly for rated
   Ø an enhanced yield when compared to similarly risky corporate bonds.

In addition, it has been suggested that the securitisation process helps integrate the
commercial property lending market with the wider capital markets. This reduction
in segmentation helps to overcome periodic problems of capital flow (the “capital
crunch” mentioned previously), improves capital market monitoring of the real
estate market and may result in lower interest rate spreads and high loan to value
ratios for property borrowers (in essence, lenders can adopt more liberal policies
knowing that the loans can be securitised and risk spread post-arrangement).

Many of the advantages identified above apply equally to asset-backed
securitisation. Here, a firm, which could be a property or an operating company,
raises capital secured on the values and income stream, if any, of their real estate
assets while usually retaining ownership. For a corporate real estate securitisation,
the assets offered as security need to be ring-fenced as a protection against
insolvency problems. In both cases, the securitisation allows the owner to raise
capital from new sources, tapping the capital markets. It is generally argued that this
results in a reduced cost of borrowing. The sources of this lower cost include the
spreading of risk and lowering of entry costs for investors and the creation of a
tradable (and theoretically liquid) asset from one that is illiquid and thinly traded.

Securitisation of income streams from tenanted properties has, in a number of cases,
been asserted to reduce costs further since the rating of the securities has been based
on the covenant and credit rating of the tenants, which may be higher than that of the
landlord. Provided that the leases are at least equal in length to the maturity of the
bond or paper, this provides a high level of security for the income stream. Properly
structured, such offers can be tax efficient and can take assets off balance sheet where
this is seen to be advantageous. Finally, it has been asserted that the success of asset-
based securitisation shows that the property market is undervaluing the safe bond-
like income produced by the standard UK lease form. As a result, by focusing on the
risk profile of the cashflow rather than on a conventional loan-to-value ratio, higher
sums can be raised: “with the right structure, a debt securitisation can raise close to 90-
100% of the real estate whereas, if the borrower used the security for a conventional loan or
debenture, lenders would insist on a LTV of 60-80%13 ”. Firms can use the capital released
to retire more expensive debt, alter the maturity profile of their debt, free up
conventional borrowing lines or expand their business activities.

The literature notes that there are costs and disadvantages associated with such an
asset-based securitisation. As with a conventional commercial mortgage-backed
securitisation (CMBS), the arrangement, underwriting, rating and credit
enhancement costs must be met. Further, the terms of the securitisation may reduce
the firm’s flexibility in managing its property assets – there may be constraints on
disposal, on reletting and on change of use. These can to some extent be overcome in
the structuring of the issue. For example, sales may be permitted subject to
substitution of other properties that meet a set of criteria (broadly, that the
substitution does not affect the rating of the bond or paper).

The majority of the benefits and, indeed, the disadvantages are claimed rather than
substantiated in the published literature. This does not imply that there are no
genuine gains, only that they need to be fully evaluated. Further, some of the claims
appear to be inconsistent with models of the operation of financial markets (for
example, in that there are winners but no losers). This implies either market
inefficiencies14 and barriers, or that there are unforeseen or unreported costs. In the
following chapters we provide a framework for analysing the claims and apply this
to some of the vehicles advanced. Here, we outline some of the vehicles and
investment schemes brought to the UK market in recent years.

Commercial Mortgage-Backed Securitisation (CMBS) in the UK

Within the UK, public attention was drawn to CMBS by two deals in 1994: the
placement of £108million of paper, secured on loans issued by the United Bank of
Kuwait (UBK), and some £150million by Bristol and West, both issues arranged by
Goldman Sachs with Freshfields as legal advisors. The Bristol and West deal

13   Catalano & Frampton (2000)
14   We use market inefficiency in its technical sense here, that there are pricing anomalies
     caused, for example, by segmentation of markets or information asymmetry.

involved careful negotiation with the rating agencies to select properties, with the
agencies focusing on the quality of the underlying property leases rather than on the
borrower, following US CMBS underwriting practices. Most of the loans were small,
with favourable LTV ratios. The securities were issued via a special purpose vehicle,
CLIPS, with the senior tranche of nearly £124m rated AAA by S&P. The UBK deal
represented around a third of its loan portfolio and consisted of thirty loans
diversified by sector and region. The senior securities paid just 20bp over three
month LIBOR. Again, much of the issue was AAA-rated, with the capital used to
seek new lending opportunities.

These deals paved the way for further, similar, activity. For example, in 1999,
Goldman Sachs arranged a £108million securitisation for Charterhouse Bank, based
on multiple loans secured on 88 commercial properties, with the Class A paper
(£89million) rated Aaa by Moody’s. Similarly, in September 2000, Monument
Security 1 issued £388million floating rate notes, secured on 130 mortgages
originated by the Anglo Irish Bank covering 337 properties with multiple borrowers.
The properties were diversified by sector and location although the five largest loans
made up 29% of the portfolio. The issue, arranged by Merrill Lynch, was arranged in
five tranches, with the largest, over 75% by value, being again rated Aaa by Moody’s.
The issue raised around 71% of the nominal value of the debt, with a debt service
coverage ration of nearly 1.5 after accounting for costs and credit enhancement. The
Bank stated that “our motivation for doing this was capital efficiency, we have a policy of
leveraging up against core equity. This is a new weapon in our armoury15 ."

In the US, much of the CMBS market is dominated by specialist vehicles, REMICS –
Real Estate Mortgage Investment Conduits – which originate, or sometimes pool,
and then securitise loans. Conduits were introduced into the UK market by Morgan
Stanley in 1999 with their European Loan Conduit Number 1, a floating rate note
offering of £169million backed by 13 loans across the UK. The £135million class A
tranche was rated AAA by S&P and paid 55bp over LIBOR. ELOC1 was followed by
three further, larger issues of around £350m each. The conduit allows the bank to
make larger loans without needing to organise syndication, with the securitisation
freeing capital for further lending. The problems associated with establishing high
volume conduit business relate to profit margins. With a highly competitive single
loan market, particularly as a result of the activities of German mortgage banks,
margins are low, which offers much less scope for securitisation than in the US.

Asset-Backed Securitisation in the UK

In parallel to this conventional CMBS development, the 1990s saw the slow
development of an asset-backed securitisation market. Early examples of
securitisation included the Nursing Homes Properties issue, secured on leases
acquired in sale and leaseback deals, raising around £100million via a series of
floating rate notes issued by an offshore SPV with tranches rated from AAA to BBB.

15   Estates Gazette, 23 September 2000.

Difficulties in the nursing homes sector and the downgrading of the rating on some
of the notes dampened enthusiasm but the late 1990s and 2000 saw securitisation in
specialist areas, backed by pub leases, theatres and airports. A number of these were
whole business securitisations (e.g. the Punch Taverns issues) but others related to
specific developments. The rental income stream from the Ashford international rail
terminal was securitised in a refinancing deal between John Laing and Barclays,
unusually using a limited partnership as the issuing vehicle (in a parallel to the US
residential MBS market, the issue was highly rated since there was a government
guarantee on some of the income stream). Capital and Income Group raised
£343million in 1998, secured on six central London offices and MSDW issued
£462million of bonds backed by a single loan to facilitate the transfer of six shopping
centres between MEPC and Westfield. However, three commercial property deals
contributed most to market awareness of securitisation: the Broadgate, Canary Wharf
and Trafford Centre offerings.

In February 2000, Trafford Centre Finance Ltd issued notes secured on Peel’s 130,000
square metre Trafford Centre regional shopping centre. The deal, arranged by
Deutsche Bank raised £610million, with £390million rated Aaa by Moody’s and
Triple A by Fitch/Duff & Phelps. While the notes are secured on a single property, it
consists of 270 separate units, 97% let at time of issuance, providing a high degree of
diversification, though vulnerable to general and regional trends in consumption and
retail behaviour. The issue represented a loan to value ratio of around 69%, although
some of the capital raised was allocated to reserve and liquidity funds to ensure the
high ratings of the class A bonds. As part of the conditions of issuance, restrictions
are placed on the terms of lease that can be agreed for incoming or renewing tenants,
on sales and acquisitions and on further lending – an issue we consider further
below. The Class A, B (rated Aa2) and D (Baa2) fixed rate notes pay coupon of 6.5%,
7.03% and 8.28% respectively.

Canary Wharf group have made two major debt issues secured on the Docklands
office development. The first in 1997, pre-flotation, was a £550million Eurobond
issue, underwritten by Morgan Stanley and secured on the rental income of the site.
Two types of paper were issued, a thirty year stepped coupon bond and a thirteen
year floating rate note. The proceeds were used to refinance and produce working
capital. In 2000, Schroder Salomon Smith Barney (with MSDW) structured a
financing of £475million secured on three office buildings, retail space and car
parking at Canary Wharf. The issue included provision for an additional £250million
in variable funding as an extension to the loan facility. The notes have a complex
structure with different amortisation schedules. The class A notes have the highest
(Aaa) credit rating. The overall high credit rating (and, hence, lower interest rates) of
the issue reflect both the credit rating of the office tenants (CSFB and Texaco, both
A1, and Citibank Properties, Aa2) and the leases, which expire between 2015 and
2026. The retail property, with over 120 tenants, provides some diversification
although, presumably, the success of the retailing is dependent on the fortunes of the
financial services office occupants.

The £1.54billion issue of bonds secured on the rental income of thirteen Broadgate
offices has been the largest UK property transaction to date. The deal, organised for
British Land by MSDW, involves issue of seven classes of notes, most of which have
a long expected maturity. All the A class notes (£785million) have the highest credit
rating and even the D notes have a rating of Baa2 from Moody’s. The issue therefore
has a far higher credit rating than that of British Land itself and, once again, this
relates to the rating assessment examining the credit rating of the underlying tenants
and the terms of the leases. Principal tenants included major financial services firms,
most leases had in excess of fifteen years to run and there were limited break clauses.
The major rating agencies comment on the FRI and upward-only nature of the leases.

The overall interest rate cost to British Land of the issue was assessed to be 6.1% and
the proceeds allowed them to buy down more expensive debt reducing overall
weighted cost of debt from 8.9% to 7.4% according to their own post-issue release,
though a revised figure of 7.05% was later quoted in the property press. This
reduction reflects both the rating of the Broadgate issue and the longer maturity of
the bonds in relation to British Land’s pre-existing debts. As we argue below, some
caution is necessary in interpreting these figures. Each of the buildings is held by a
separate subsidiary property company, with the bond issuer taking a first mortgage.
Strong restrictions are placed on the borrower’s activities and there are substantial
information requirements. Effectively, the Broadgate properties are ring-fenced from
the rest of British Land’s activities, preventing any cross-collateralisation. Overall,
the issue represented a loan to value of 73% of the open market valuation with a
DSCR of 1.3. The one-off cost of the issue was reported to be £68million or around
4.4% of the capital raised.

The proposed £122million issue by Workspace, arranged by WestLB, shows that it
may not be vital to have trophy buildings and high covenant tenants to raise funds
via securitisation. This is a whole business securitisation where the range of property
types, locations, types of tenant and lease lengths is intended to provide a portfolio
diversification effect, reducing overall risk compared to lending secured on
individual properties. Should the deal come to the market, the reaction will be
interesting, since, in contrast to the high profile issues discussed above, Workspace’s
typical lease is short (often with just three month’s notice) by comparison to the debt
maturity, 75% of which has a maturity of five years or greater, and the tenants are
unlikely to have strong credit ratings. The security of the issue depends on the
diversity of the portfolio of tenants and the belief that default risk is unsystematic16 .
Evidence to support this belief comes from the 1990s market experience but some
more extreme market conditions may undermine this belief.

16   If tenant default risk is systematic, in a severe market downturn, the number and extent of
tenant default might increase substantially leading to investors requiring a higher return to
compensate them for the increased risk. It is up to the issuer and rating agencies to determine
how much risk is attached to the constructed portfolio but ultimately it is the investors who
value the security.

The size of the Canary Wharf and British Land Broadgate issues is symptomatic of
the growth of the UK and European CMBS and asset-backed securitisation market.
Moody’s Investors Services estimate that the total property-related bond issuance in
Europe rose from €2.7billion in 1998 to €8.5billion in 1999 and then to €10.7billion
in 2000: they forecast a further rise to €14billion in 2001. JP Morgan point to a similar
trend with CMBS issuance averaging around $2.4bn between 1994 and 1998,
climbing to $8.6billion in 1999 and over $10billion in 2000. While still small by
comparison to the US market, where there was issuance of over $50billion in 2000,
the growth suggests that the market is becoming firmly established. However, in
order to establish a sufficient scale to provide liquidity and reduce issuance costs, it
is likely that pan-European issues will be needed. Rheinhyp’s Europa One issue
which raised £1.35bn secured on 75 loans and 99 buildings spread across five
countries illustrates both the possibilities and the constraints, the issue being a
“synthetic” CMBS, secured on Pfandbriefe, to avoid problems of the different
jurisdictions. With the UK dominating issuance and remaining outside the Euro
zone, an additional layer of currency risk is added.

                          European CMBS Issuance:
                               Annual Volume







                   1994   1995   1996   1997   1998   1999   2000

                                 Source: JP Morgan

Sale and Leaseback and Off Balance Sheet Ownership Structures

For firms wishing to raise capital from their corporate real estate, a traditional
alternative to structured lending has been sale and leaseback. Traditional sale and
leaseback is off balance sheet, at least until the proposals to revise FRS12 and bring
operating and financing leases into line are implemented, the rent provides a tax
shield and it may be possible to raise the full capital value of properties.
Disadvantages include the potential loss of capital allowances, partial loss of control
of the assets, loss of any capital growth potential, loss of an asset that can be used to
secure further borrowing and, possibly, uncertainty at the end of the lease term. Most
of all, however, since traditional sale and leasebacks operated on traditional

institutional style leases, the firm was exposed to risk from the rental market and
faced upward-only rent reviews.

There have been recent attempts to create structures that are more flexible than the
traditional model. Of these, the one that has received the most attention has been
“Project Redwing”, the J Sainsbury’s sale and leaseback which was accompanied by a
bond issue to raise the capital. The sale and leaseback involved the sale of sixteen
supermarkets to an offshore SPV. The stores were then leased back on twenty three
year leases with rents increasing by 1% per annum rather than being reviewed to
market. Sainsbury’s are able to substitute stores, subject to satisfying value and credit
rating tests, providing a measure of flexibility. The capital is raised by the issue of
£336million secured bonds by the Highbury Finance special vehicle. The bonds are in
a single class and are partially self-amortizing to £170million. At maturity,
Sainsbury’s has underwritten any shortfalls between the value of the stores and the
redemption value, a liability that presumably brings the transaction back on balance
sheet. They also have an option to repurchase the stores at market value or take a
further 20 year lease. The bonds pay a fixed rate coupon of 7.02% and were initially
rated A1 by Moody’s but subsequently downgraded to A2 given the difficulties in
the general retailing sector. According to statements by the company, this 7% cost is
considerably lower than the cost of a conventional sale and leaseback IRR, which has
been assessed at closer to 10% over the life of the lease. Subsequently, Sainsbury’s
conducted a second sale and leaseback transaction on similar terms, securitising the
rents of ten stores to raise a further £232million. The capital was raised with a
floating note issue in three tranches, the top two classes being rated A2.

In 1999, Shell sold 180 freehold or long leasehold petrol filling stations to a joint
venture between Rotch and London & Regional, both private property companies.
Shell released capital from the sale, took the assets off balance sheet and realised
some tax efficiencies. The filling stations were leased back, again on long (18 year)
leases with a five yearly rent review formula that took rents to the higher of market
rent or 2.5% p.a. compound growth – a formula that seems to give the purchasers a
guaranteed real return over the short to medium term. The sale price was £300m
which was debt funded on a 90% loan-to-value ratio reflecting the favourable rental
terms and Shell’s covenant. The rent fully amortises the debt over the lease length,
leaving an unencumbered residual capital value. Shell has limited rights of
substitution and rights to vacate stations.

Another transaction that attracted much attention was Abbey National’s £457million
sale of its property interests to Mapeley, the Delancey Estates / George Soros backed
outsourcing vehicle. The entire freehold and leasehold estate – 1,300 properties and
some 604,000 square metres of space – was transferred, with properties leased back
for terms varying between one and twenty years. The unusual aspect of the deal is
that the outsourcing included leasehold interests as well as freehold properties,
raising complex valuation issues. Abbey National retains the right to repurchase
some of the freehold properties. Rents on the leased back properties will rise on a
stepped basis, at 3% per annum. While this creates greater certainty and obviates the

need for costly rent reviews, it seems a fairly high rate of growth (see below). Abbey
National was reported as making an overall profit of around £70million on an initial
rent roll of £80million. However, it was argued that the driving motivation was to
obtain flexibility in structuring the corporate property portfolio. In interviews, we
were informed that further developments were likely.

The Abbey National deal, in effect, outsources the corporate real estate function. The
government’s private finance initiatives – the disposal of MoD homes to Annington,
the Trillium Prime scheme for DSS offices and the STEPs scheme to dispose of 600
Inland Revenue and Customs & Excise properties – have helped create an interest in
complete outsourcing of property ownership, leasing and management, and created
specialist companies operating with public and private clients. Recently, BT
announced a massive outsourcing scheme involving its entire six million square
metre UK portfolio with a rent roll of £400million p.a. and £200million annual
facilities management costs. Such outsourcing allows a firm to concentrate
investment and management on its core activities; it provides transparency both
internally and for shareholders as to real estate costs; and it may enable a
restructuring of its corporate real estate on a more flexible basis. However, cost-
benefit analysis is made difficult in many firms since the total costs of occupation
(space, facilities management and services) are rarely collated or kept on a consistent
basis. Similar problems are faced in appraising the benefits of serviced offices
compared to conventional lettings.

Equity Investment Vehicles

It is beyond the scope of this report to provide a detailed discussion of the search for
tax efficient equity investment vehicles. Since the late 1980s, there have been calls for
the establishment of a tax transparent vehicle akin to a US Real Estate Investment
Trust, particularly if this could be used to subdivide the ownership of single
properties or developments. The Barkshire committee, amongst others, has been a
strong advocate for creation of single asset vehicles but to date these have achieved
neither tax transparency nor DTi/Treasury approval. More recently, hopes were
expressed that limited liability partnerships could be used to create a near-REIT
equivalent. Complications regarding tax, following government announcements on
status, listing and trading frustrated these hopes. Similarly, the Authorised Property
Unit Trust market failed to develop into a significant force in UK property

The major growth area in recent years has been the use of Limited Partnerships (LPs)
to share ownership and pool investment in real estate. Over £5billion flowed into
limited partnerships between 1998 and 1999 with major deals including BAA
Lynton’s creation of limited partnerships for its properties, such as the £200million
hotel offering, Barclay’s Property Investment’s Whitgift Shopping Centre
partnership, the Lend Lease Retail Partnership, a £500million shopping centre
portfolio, the THI leisure fund, Tower 42 (Greycoat, Hermes and MAM, £226million)

and the Birmingham retail alliance between Hammerson, Land Securities and

The limited partnership structure, under the 1907 Act, ensures that there is no tax
within the partnership, each partner being individually liable for tax on income and
capital gains. It is tax transparent, although there are some problems associated with
foreign partners. As collective investment schemes, LPs require an FSA-authorised
operator. The LP structure is useful for risk sharing, despite the limit of twenty
partners, but it does not provide liquidity since, at present, partnerships cannot, in
the UK at least, be listed and traded publicly. To exit from a partnership, an investor
must find someone to take on their stake and obtain the approval of the remaining
partners for that replacement , since there is no active secondary market. As a result,
most partnerships have a finite life, which raises the possibility of forced sale values
on expiry if the partnership is not extended. The general manager can raise debt but
to date most have been cautiously geared. The emerging trend has been for limited
partnerships to focus on specialist property and management, allowing investors to
gain exposure to niche markets or, as in the case of the Lend Lease partnership, to
assets that, acquired individually, would be very costly and take up a high
proportion of a typical investment portfolio.

Tax changes have led to investors seeking new ways of holding real estate assets. In
particular, recent increases in stamp duty have led to a restructuring of commercial
property investments as special purpose vehicles. The Stamp Duty Acts prevent a
firm creating such a vehicle when it is actively contemplating or negotiating a sale.
However, a number of property companies, including British Land, Delancey,
Greycoat and MEPC, have reportedly moved to place property assets into SPVs,
enabling future sales to be completed with low tax costs. The SPV could also be
offshore, with the legal title remaining in the UK, at nominal value, and the beneficial
title with all the value registered abroad. The Wates City of London portfolio
acquired by Pillar will be transferred into a Jersey-registered unit trust, for example.
While tax efficient, offshore trusts do expose investors to legislative and political risk;
they are administratively complex; and the timing and nature of repatriation of
funds adds an additional layer of complication to analysis.

Property Derivatives

In contrast to other capital markets, the growth of property-related derivatives has
been slow. In part, this reflects the lack of transparency, the low frequency and slow
publication of property data. For an active secondary market to develop, there needs
to be a measure of volatility, a flow of information and differences of opinions
between potential buyers and sellers to ensure trading. The failure of London FOX
and its property futures did not help to instil confidence on the fledgling market, and
institutional attempts to establish a market have yet to bring results. Barclays bought
two products to market: Property Index Certificates which offer a synthetic
investment vehicle offering low cost exposure to the property market linked to IPD
capital growth and income return; and Property Index Forwards, a forward contract

again based on IPD. These are privately placed over-the-counter products, with
Barclays (BZW at initiation) acting as market maker. Although they can theoretically
be used as a hedging instrument17 , the fact that they are based on the IPD all-
property index, rather than linked to particular market segments, creates tracking

More recently, there has been a growth in interest in swaps with, inter alia, the
Prudential advocating the creation of a “property total return swaps” (PTRS) market.
In concept, a PTRS market would allow investors to swap a fixed amount of, say,
City office returns for a matching amount of, say, South East retail returns. The
settlement would, in all likelihood, be based on IPD indices. This would allow funds
to manage their property portfolios in an active manner without incurring large
transaction costs. The success of such an initiative depends on the creation of an
active secondary market which presumes a critical mass of trades. This, in turn,
depends on there being differences in opinion on the future trajectory of different
market segments. As with PIFs, the heterogeneity of property causes problems in
tracking the index. For example, a fund swapping its office returns for retail returns
might find that offices in general outperform retail, requiring it to pay out on the
contract while its own offices had under-performed the market, creating a double
loss. (The converse is, of course, also possible).

The property industry has used derivative products to hedge finance and funding
arrangements such as interest rate risk and, with more difficulty, to control for
currency risk in international real estate transactions. However, the development of
investment-related derivative products is still in its infancy. Given the apparent
interest in the market and preparedness to overcome regulatory barriers, it is likely
that the market will grow. Nonetheless, it is likely to remain an over-the-counter
market with one-off transactions between professional investors, with an important
role for intermediaries for some time to come.

17   See Eales and Matysiak (1998).

A Historical Perspective

It would be wrong to suggest that the securitisation deals and new vehicles of the
late 1990s and 2000 have no UK antecedents. In the late 1980s property boom, there
were many new funding and financing mechanisms that drew from the liberalisation
of capital markets and the wave of financial engineering in that period. Pryke (1994),
for example, reviews the use of innovative funding methods in the central London
office market that sought to increase the flow of capital and widen the sources of
capital away from traditional bank and institutional providers. This can be seen in
the wide range of debt and hybrid debt-equity vehicles, such as zero coupon, deep
discount or stepped coupon bonds, that aimed to defer payments with the hope of
exploiting capital growth or share profits between lender and developer via
convertible mortgages or profit sharing loans. In addition, more complex corporate
structures took many schemes off balance sheet. As now, investors sought tax-
efficient equity investment vehicles that would allow sub-division of the cashflow of
major buildings – the widely-discussed SPOTs, SAPCOs and PINCs.

The property market downturn of the early 1990s exposed the fragility of many of
these schemes which had been reliant on the continuation of property market
conditions (deferred payment schemes, for example, relied on continued rental and
capital growth, which was not delivered). The legacy of the property crash –
company failure, debt default and portfolios of under-performing loans – led to
highly conservative attitudes amongst lenders. Meanwhile, continued Treasury and
Inland Revenue resistance to the creation of tax-transparent vehicles and the poor
performance of the few vehicles actually established, notably Billingsgate Securities,
restricted the development of new investment routes. Further, one significant
economic rationale for such schemes – the yield spread between large and small
buildings due to entry barriers and lot size – ceased to hold as the newly liberalised
German open-ended funds sought high yielding external investment assets.

The early 1990s saw a number of asset-backed property securitisation deals. One
much discussed was the BHH securitisation, arranged by Paribas with the
involvement of insurer FSA. BHH obtained a loan of £90million from an issue of
floating rate notes secured on 33 mortgages on BHH property. The loan value
exceeded the market valuation of the properties but some of the proceeds had to be
retained to provide interest rate cover. Nonetheless, the effective loan-to-value ratio
of around 75% was greater than the then bank standard of 60-65% and the effective
interest rate much lower than comparable bank lending margins, enabling BHH to
buy down expensive debt. The deal, allowing for the costs of FSA and other
guarantors, arrangement and underwriting fees, the cost of interest rate caps and so
on, was costly. There has been little public analysis of the long- run impact of the
deal or the performance of the notes, BHH being taken over by I.M.Group in 1992.

In 1992, RSD issued commercial paper in the US secured on the rental stream
provided by the tenant National Westminster of one of the Broadgate office
buildings. The notes, subject to credit enhancement provided by FGIC, were rated at

least in part on the tenant’s credit status, permitting AAA ratings. The issue raised
$178million, an LTV of around 63%, with a modest saving on borrowing costs. The
debt was refinanced in 1996 through a specialist vehicle, TAGS, organised by
National Westminster. This raised £114million through commercial paper paying
40bp over gilts and pushed out the maturity of the debt. This financing meant that
the property was excluded from the British Land securitisation discussed above.

1992 also saw the issue of £100million zero coupon bonds by Redcastle, a subsidiary
of Burton Group. These were secured on a property portfolio consisting of shopping
centres, a retail park and offices with substantial vacancy rates. The security of the
redemption amount was obtained by a number of institutions taking options on the
buildings exercisable at the bonds’ maturity date. This additional security allowed
the firm to raise a loan equivalent to around 61% of the value of the troubled
portfolio. In another 1992 issue, Barings organised the securitisation of income from
the Times building in Gray’s Inn Road, the rating boosted by the secure covenant of a
government tenant. Two years earlier, Stanhope had issued convertible mortgage
bonds for a value of £119million, secured on another Gray’s Inn Road office building.

Three years earlier, Speyhawk raised £55million on Kings Cross House, again let to
National Westminster, via a secured issue of bonds with a ten year maturity and a
coupon of 12.1%. The rental income was less than the coupon, requiring credit
enhancement – internally via retaining £15million in a cash collateral account. Bond
holders took a timing and a redemption risk: as with the more recent transactions,
the tenant’s covenant was thus critical in making the issue acceptable to investors.
These early single tranche issues were reviewed by Clifford Chance (1992), who set
out the basic structure of income-backed issues and identified the potential
problems: insolvency of tenants leading to default or delinquency in interest
payments; falls in capital values jeopardising redemption; and problems in selling or
refinancing the assets causing timing problems at maturity.

A View From the US

While there are many similarities between UK and US real estate practice, there are a
number of clear differences in terms of the investment vehicles available, the analytic
techniques used to appraise their worth and the methods used to fund and finance
the supply of commercial and industrial real estate. In turn, this produces differences
in tenure structure and terms. Compared to the UK (and, in particular, to mainland
Europe), the US has lower levels of owner-occupation and more flexible, tenant-
favourable lease terms. This in turn seems to relate to a more elastic supply side,
though with associated higher structural vacancy rates. This apparent flexibility has
not, of course, prevented cyclical behaviour, booms and slumps both nationally and
in local markets.

One important theme that emerges from an examination of the US experience is the
important role played by market structure. Particular, contingent market structures
and conditions lead to the creation and success of particular vehicles and products.

This can be seen, for example, in the nature of the rating process, the importance of
tax changes and in the role of government.

The US lease length (typically five or, at most, ten years), the terms of that lease
(rents adjust to market levels) and the stronger position of tenants18 create a situation
markedly different from that in the UK. This has not prevented investment flows into
real estate nor the development of securitised, public market products. However,
rather than focus on tenant covenant and the lease, analysis has placed more stress
on the quality of the building, the economic prospects of the market and other
cashflow drivers. This view is embedded in credit rating methodology which, in
turn, has influenced the methods used to assess US property-related securitisation.

Tax changes have had a major impact on the US real estate market. In particular, it
was tax changes that led to the rapid rise of the Real Estate Investment Trust market
which increased from less than $2billion in 1972 to $44billion in 1994 and then to
$139billion in 2000. Subject to meeting a set of investment and management criteria,
qualifying REITs are able to pass through their rental income less costs direct to
shareholders without encountering the problems of double taxation facing UK
property companies. This represents a considerable advantage to tax-exempt
investors, without disadvantaging private investors who do not face large entry or
transaction costs, in part explaining the growth in the market . The inflow of capital
into the market in the early 1990s meant that REITs were able to outbid institutional
and foreign investors on the majority of private transactions in that period, resulting
in a major transfer of ownership. Since REITs are not obliged to publish the market
values of their real estate assets, they are valued in terms of their dividend stream
and history of earnings growth. In the second half of the 1990s, REIT performance
declined relative to the stock market as a whole: as with property companies in the
UK, this reflected market sentiment and the focus on growth stocks, particularly in
the technology sectors.

18   Presumably related to greater supply side elasticity in comparison to Britain.

Figure 2: REIT Market Capitalisation 1971-2000



          Market Capitalisation $m






Source: National Association of Real Estate Investment Trusts

Tax changes also drove the development of conduits in the mortgage-backed
securities market. The Tax Reform Act of 1986 created a transparent pass-through
vehicle, the Real Estate Mortgage Investment Conduit (REMIC), which transformed
the market place. Conduits capitalised on earlier developments in the mortgage-
backed securities market, notably Collateralised Mortgage Obligations (CMOs). The
CMO structure allowed issues to contain separate tranches of bonds with different
maturities and cashflow profiles. The development of a tranche, an accretion or Z
bond which paid no interest but which accumulated and accrued interest and paid
out when all other classes had been repaid, allowed the earlier tranches to receive
still higher ratings. The tranche and REMIC structure meant that senior bonds in
commercial mortgage securitisation transactions were receiving AAA ratings by the
late 1980s. Recent UK deals echo the structure of these US vehicles.

There was a strong government role in the creation of a mortgage-backed securities
market. The establishment of the Resolution Trust Corporation by the Financial
Institutions Reform, Recovery, and Enforcement Act of 1989 was prompted by the
Savings and Loans and banking crisis of the late 1980s. Resale of pooled commercial
mortgages by the RTC helped create the CMBS market. In turn, the CMBS market
drew on the success of the residential mortgage-backed securities market that had
grown rapidly in the 1980s based on the creation of a secondary mortgage market by

the federal credit agencies19 . The role of the government as a guarantor of payment
and the standardisation of mortgage forms allowed the market to grow rapidly,
while developing analytic tools that could be adapted to cope with the more
heterogeneous commercial mortgage pools20 . The size of the mortgage-backed
securities market in the US has created great liquidity and driven down set up and
transaction costs. This will be hard to replicate within a national context in Europe.
As noted above, pan-European products are complex in the absence of convergence
in institutional and legislative structure and, at least in the UK case, in the presence
of exchange rate risk.

Asset-backed non-recourse securities appeared in the early 1980s in the US. In 1984,
Salomon Bros. arranged a $970million floating rate note secured on three Manhattan
offices, owned by Olympia and York (O&Y), on a non-recourse basis. These notes
were not rated and paid 175bp over the three month Treasury Bill rate: the private
placement was reported to be fully subscribed. In 1985, American Express obtained
$509million funding for a headquarters building in the World Financial Center using
a five tranche limited recourse structure with the senior class rated AA. In 1986,
another O&Y deal raised $200million secured on three tenancies of a Manhattan
office development. The deal represented a loan-to-value ratio of 70% and cost, after
allowing for credit enhancement, about 60bp less than traditional funding but
offered investors around 30-35bp more than equivalent rated corporate bonds. An
early review of the transaction spoke of a “win-win” situation with the issuers
having greater flexibility in structuring the loan and obtaining cheaper capital than
conventional routes, while investors received an enhanced yield, the security of a
rating, liquidity and the opportunity to invest in high quality properties and a
quality company21 . This might be seen as ironic in the light of O&Y’s subsequent
history and the performance of the New York office market in the late 1980s, but
finds an echo in contemporary reporting of similar UK deals.

The US experience suggests that there is much scope for growth and development of
innovative debt and equity vehicles. However, it is clear that the particular form of
real estate vehicles results from a combination of market conditions, market
structure, tax and legislation. It is thus not possible to draw direct comparisons
between the UK and US markets nor to suggest that existing US vehicles can simply
be parachuted into the UK market. Nonetheless, the US experience in structuring
deals and in providing research and analysis of the risk and return performance of
new vehicles is of great value in the developing British and European markets.

19   The Federal National Mortgage Association (Fannie Mae); the Government National
     Mortgage Association (Ginnie Mae) and the Federal Home Loan Mortgage Corporation
     (Freddie Mac), the last a private-traded enterprise, albeit state-sponsored.
20   For a review, see Vandell (1993).
21   Manolis & Meistrich (1986).


The last decade has seen considerable change in the UK property market. The
aftermath of the property crash and the overhang of supply at the start of the 1990s
allowed tenants to obtain shorter and more varied leases. As supply and demand
moved back into balance, some of these tenant gains have been lost. Nonetheless, the
terrain at the start of the millennium looks very different. Not only are conventional
leases more varied, but new forms of occupation and procurement have also
emerged. The serviced office sector has matured and expanded, and outsourcing of
total property requirements has become more common, following the experience of
PFI schemes. Investors and valuers increasingly use new and more sophisticated
analytic tools to assess the potential of real estate projects. The trend towards
internationalisation has continued, with the majority of large West End agents and
advisors now part of global alliances. At the same time, other business and financial
services firms, notably management consultants and accountants, have captured a
larger share of property market business. These trends have reduced the isolation of
property from the other capital markets.

These same trends have helped fuel innovation in funding, finance and investment.
The search for tax-efficient and liquid equity investments has continued, while
securitisation of debt markets has grown considerably in importance, probably
reaching a sufficient critical mass to be self-sustaining and drive down costs. To an
extent, the innovations of the last decade represent a continuation of developments
in the 1980s that followed liberalisation and deregulation of financial markets, with
the aftermath of the property crash in the early 1990s marking a pause in a longer
run trend. Although the securitised real estate market is nothing like the scale and
significance of that seen in the US, it is unlikely that there can be any return to a
reliance on the traditional model.

In the published material on the recent deals and transactions outlined above,
numerous claims are made about the benefits of the scheme for the borrower / issuer
and for the investor. Frequently, all parties are said to gain from the deal. Inevitably,
this arouses concerns: “there’s no such thing as a free lunch”. To evaluate such claims, it
is important to examine the rationale for the deal, the possible sources of added
value and the way that value is apportioned amongst parties to the deal. In the next
chapter, we seek to develop an evaluative framework to inform that appraisal.


Considerable entrepreneurial effort is devoted to creating and adding value, and one
firm may take over another in the belief that the combined firm will be more
valuable than the two separate entities. Similarly a property developer may
assemble, through a series of discrete purchases, a site that can yield additional value
when developed as an entity. Within the area of valuation, the creation of marriage
value also reflects the recognition that by combining or recombining two assets, it
may be possible to create a third asset that is more valuable than the sum of the
parts. In the history of capital market research, much effort has been expended on the
search for robust methods of adding value to firms through innovative financial
products. Research has often demonstrated the fallacies behind traditional
arguments for some engineered solutions but has also shown how innovative
techniques and products can contribute to corporate value. We therefore produce in
this report a brief typology of financial themes that can be perceived to add value for
firms through operation of the financial markets. In our review we also aim to show
the limitations of other arguments that are sometimes erroneously used in analysing
the financial problem too simplistically.

Central assumptions about financial markets.

In uncovering the source of value-creativity in the financial markets, an enormous
amount of research effort has been expended. There has been a mixture of methods:
protocol analysis, and experimental and stock market price-based research. In both
the US and UK, the overwhelming findings are that the capital markets are broadly
efficient, insofar as it is extremely difficult to establish financial techniques that will
deliver superior returns to shareholders. In other words, it is difficult to create added
value. The work has involved the examination of publicly available information such
as Annual Reports and Accounts, and less widely circulated information such as the
information implied by Directors’ share dealings, the price impact of company
presentations to invited investment analysts, window dressing techniques in
financial reporting and the dissemination of recommendations by brokers.

How do businesses add value through financial operations?

Just as in every other market, entrepreneurs and innovators are able to earn extra
profit by identifying a latent demand and quickly supplying products that will meet
that demand. In the modern global economy, the window of opportunity in which
innovators can exploit their foresight has become much shorter as competitors soon
identify the innovators’ source of value and produce similar financial products. The
financial sophistication embedded in many of the new financially engineered
securities bears almost no comparison with the techniques and approaches used even
a decade before. However, sophistication does not necessarily lead to added value
and the discussion below highlights some of the ways in which the value added may
not be as great as it appears at first sight.

Innovation in securities – Debt and Equity

The analysis of debt finance has produced a large volume of research which has not
yet satisfactorily resolved the issue of whether value is added to companies by
structuring the debt/equity mix of their capital. Traditional finance identified that
the contribution of debt finance could be found in its tax shield but the extent and
value of this shield has proved extremely difficult to establish. In a financial world in
which there are investors who are tax-exempt and other investors who have
preferential tax positions in some debt vehicles, the financial advantage of debt from
the tax viewpoint is likely to be limited. Some authors in real estate (e.g. Geltner and
Miller, 2001) argue that the tax-shelter effect is neutral and most would agree that it
is not a significant source of value. There may be a clientele effect since there are
many investment institutions that seek investment assets which have long duration
or maturities and are constrained from investing in equities or other more volatile
securities, but the creation of value in these cases rests in the appraisal of relative
demand and supplies of each type of security, and cannot be determined simply by
supply-side analysis 22 .

The continuing use of debt finance can also be ascribed to the signalling effect of
debt. Since companies that issue debt have to cover the interest payments on it in
order to continue business, it creates a hurdle that management has to overcome.
Theoretical research argues that management will only create such hurdles if it is
confident that the company’s future looks adequately secure. The corollary of this
argument is that firms that do not issue debt when they have assets that could
provide adequate security for it are likely to lack confidence in the future of their
business. The empirical basis of these arguments is mixed but there is anecdotal
agreement in the financial markets that ensuring that there is some debt in the capital
structure is a signal that managers can make about positive future prospects of the
business23 .

Innovation in specific financial tools – leasing

Leasing in the UK expanded rapidly over thirty years ago in response to a tax-
arbitrage opportunity. Manufacturing companies commonly had accrued large
allowances against tax arising from inflation adjustments to inventory valuations.
Their capacity to offset depreciation and/or capital allowances against tax was
thereby reduced whereas financial institutions such as retail and investment banks
had not received similar allowances. Leasing was thus enabled as a vehicle through
which the financial institutions bought assets, claiming tax allowances in the form of
depreciation and capital allowances, and transferred them to manufacturers by
offering leased assets in the form of a financial package. The manufacturing sector
thus acquired additional tax-shields through leasing. Clearly this is a real added

22   Further discussion of the tax-related effects of debt can be found in Geltner, 1999,
     MacDonald, 1999.
23   e.g. Chan & Kanatas (1985), Bester (1985, 1994)

value created by the tax system. However, from time to time, claims about the
benefits of leasing have circulated which are unsubstantiated or simply misleading.
Two of the most common misconceptions are discussed below.

The “leasing provides 100% financing” argument

When a company rents a property, the amount of capital required to finance the
transaction is obviously much less than the amount of capital required to buy the
property. However, the two transactions are not comparable. In the first case, the
rental payments are fixed in the short term and at all times rank amongst the highest
priorities for payment if the lessee becomes financially constrained. Thus the liability
for rent is equivalent to the liability for a bond or loan taken out by the lessee. In
financial terms, we argue that the rental payment is equivalent to borrowing or
issuing a secured loan and, in fact, displaces the opportunity of debt.

A standard 25-year lease does indeed require less capital to enter into as a tenant
than that required if the tenant were to purchase the property to be occupied under
the terms of the lease. However, when an investor buys a property, there are
additional sources of value above the expected future streams of rent. First, there is
the reversionary value at the end of the lease. Second, there may be an option to
redevelop the property before the lease is complete. Both of these options become
more valuable the more variable are rents and yields in the property market. We can
see therefore that, from the owner’s point of view, the lease provides a value
additional to the liability attached to the tenant’s rental payments and that
furthermore the value will rise or fall depending on the relative performance of the
property market relative to the tenant’s business performance. Thus the purchase of
a property by an occupier can be represented as (1) the acquisition of working space
which may be directly compared with renting and (2) an investment in the relative
performance of the property market. Whether the latter is a source of profit or loss is
an empirical issue but is one in which occupiers may feel less disposed to finance
than specialist property investors.

It is also correct to recognise that the ownership of a property may offer less security
to a lender than the value that may be recognised in some of the modern income-
backed securities observed in the current market. In this case, it would appear that
new techniques and innovatory securitised vehicles do provide additional loan
finance when compared with more traditional debentures and secured loans. This
point will be further discussed below.

The “Off-balance sheet financing” argument

Whilst recognising that debt-displacement is a fallacious argument for leasing,
advocates would still hold that leasing is preferable since it does not appear as a loan
on the balance sheet. Thus it is believed that a company which usually rented
property would appear to be safer than a company that bought the properties it
occupied and then issued debt secured on the properties. There are two answers to

this argument. First, it is almost inevitable given the current concerns of the
Accounting Standard Board and the International Accounting Standards agencies
that companies will shortly be required to report their operational leases in a more
transparent form than is currently used to report property leases. Second, research
into the issue suggests that investors already take into account the additional risk
represented by companies entering into lease arrangements.

The risk attached to investing in the equity of a firm derives from two components:
the business risk and the financial risk. For firms in the same industry which are
broadly exposed to the same amount of business risk we can expect that the greater
the gearing, the higher should be the equity risk. Long established research (Beaver
et al., 1970, Hamada, 1972) has determined that the more debt there is reported in the
balance sheet, the higher is the risk of equity. But is this true for debt not appearing
explicitly in the balance sheet? Bowman (1980) looked at the effect of finance leases in
the US before financial leases had to be reported and found that the lease data was
reflected in the equity risk of the firms. Dhaliwal (1986) similarly found that
unfunded pension fund liabilities, which did not appear in the balance sheet
although they were disclosed in the Annual Report, were reflected in the risk of
equity. More specifically, Imhoff et al, (1993) and Ely (1995), using US data, and
Gallery and Imhoff (1998) using Australian data, have looked at the effect of
operating leases on the risk of equity.

A major problem with these studies concerns the estimation of the present value of
the lease obligations since the values have to be estimated using crude
approximations of the true, unreported values. These methods range from simply
multiplying the reported operating lease expenses by 8 (the factor 8 method) to the
more sophisticated constructive capitalisation method whereby assumptions are
made about the life of the operating leases and the appropriate discount rate. Beattie,
Goodacre and Thomson (2000) analysed a sample of 161 UK companies and found
that an improved estimate of equity risk resulted when the effect of operating leases
was taken into account. This result implies that investors in the UK were aware of
the underlying effect of operating leases. This, in turn, implies that there is little or no
benefit, even in the present regulatory accounting standards reporting regime, from
the off-balance sheet argument for leasing. However, in passing, we note that one
effect of the circulated draft accounting standards on lease reporting would be a
dramatic increase in the reported gearing of UK firms; Annual operating lease
liability in the UK has been estimated to be 39% of reported long term debt. Beattie,
Edwards and Goodacre (1998) estimated that if this were to be reflected in the
balance sheet of UK firms, the net debt/equity ratio would increase by 260%.

One implication of this is that methods that are concerned with off-balance sheet
financing may not deliver extra value to the financing company. Indeed there is a
small literature in the UK on the effectiveness of investment analysis of accounting
statements. Although the findings are somewhat contradictory in that individual
institutional and professional investors apparently do not understand accounting
conventions (Breton and Taffler, 1995) and that UK institutional investors are less

sophisticated than US investors (Arnold, Moizer and Noreen, 1984, Anderson and
Epstein, 1996), the specific research on leasing (see above) supports the view that
market prices reflect the underlying ‘true’ financial position rather than the position
disclosed in the main Balance Sheet and Profit and Loss Accounts.

As a corollary of the above argument, one might infer that since concealing
information does not appear to add value to businesses, releasing information might
be the preferred policy. A major concern of the Accounting Standards committees
both nationally and internationally has been to ensure that investors have access to
information in a timely and consistent form. Recent debate on the implications of the
valuation of operating leases or the true cost to the shareholders of providing share
options to senior executives has been controversial but the implications are clear.
Companies will continue to be persuaded or forced to disclose more information in
the future about financing issues than they have hitherto been inclined to give
voluntarily. Because of the arguments about market efficiency mentioned above, it is
unclear what benefit accrues to companies that provide more than the required
information to shareholders. In the property company sector, there is an annual
award made to the ‘best’ Annual Report and Accounts. Although the winners are
usually also successful companies, it is unclear whether the award implies that more
information is provided or simply the same amount of information presented more

Intermediation by Financial Institutions

Much of the innovative practice in financing owners and investors in real estate has
been made by specialist financial institutions and investment banks. It is important
to review how financial institutions create extra value in the financing process. There
are three functions that underpin the value-creation: brokerage, transformation and

Brokerage function

The function of brokerage is central to both real estate and many financial markets.
The broker’s contribution to adding value to financial products stems from specialist
knowledge. The broker stands between the borrower and the investor, and facilitates
the transaction. Given a market in which either party may participate at irregular
intervals, the existence of a specialist broker will lower the transaction costs
significantly because information about values and constraints will be readily
available. It is particularly obvious in the property market, both residential and
commercial, that agents or brokers act to make the market more effective. The lack of
publicly visible market transaction data, the consequential need for subjective
valuations and the heterogeneity of the real estate product are all factors that ensure
the viability of the broker firms. In the same way, the thinness of the market for real
estate finance, and the lack of publicly available data on transaction prices are factors
which ensure that the brokerage function is an essential source of value when new
financial products are being developed.

Given the emergence of global financial companies offering investment and financial
advice, as well as providing over-the-counter markets whereby investors can
exchange their less liquid investment assets, the brokerage function coupled with
competition between the global institutions will contribute greatly to the dynamic
performance of the new securities.


Maturity Transformation

A common characteristic of financial institutions is to act as a maturity
transformation mechanism. Traditionally in the UK, building societies carried out
this function in the retail market for housing finance by borrowing on the basis of
short-term deposits and lending long-term finance for home purchase. The difference
in maturity of duration of their assets and liabilities would seem to have caused a
large mismatch but it was mitigated by the almost universal imposition of variable
interest rates for borrowers and lenders. Alternative methods of dealing with the
mismatched loan/asset pool are (a) selling loan portfolios to investors or other
financial institutions, (b) swapping interest rate payments (from variable to fixed or
vice versa) and (c) purchasing interest rate caps or collars whereby the adverse
effects of differences between variable and fixed interest rates can be insured against.

For much of the 20th century the yield on short-term securities was lower than the
yield on longer-term securities. However this pattern was inverted in the 1990s and
the inversion has persisted in 2000 and 2001. The implication of this is to encourage
more companies to borrow on longer maturities than they would previously have
been inclined to do, thereby enhancing the substitution of short-term bank debt by
longer maturity securitised loans. Any tendency of the shape of the yield curve to
revert to its ‘normal’ shape may constrain to some extent the continuing surge in
securitised loan creation.

It would still be possible to issue long-term securitised assets that paid variable rates
of interest. However it is taken as established practice that most of the securities
issued with a maturity of less than about 5-6 years will have variable interest rate
coupons whilst most of the securities with maturities longer than 5-6 years will have
fixed interest rate coupons. Of course, as discussed above, it is still possible for
financial institutions to constrain their exposure to interest rate risk by swapping
variable interest rate payments for fixed interest rates.

Volume transformation

Volume transformation can either replicate the work of a wholesaler, whereby the
institution obtains a large financial position and distributes the security or asset
between smaller companies, or a collection agency, through which small funds are
aggregated to create a larger fund. In the wholesaling function, the financial
institutions can, because of their position acting as agents within or instead of a

market, often act to make financial assets more attractive to investors by re-
packaging them. Investing institutions create value by establishing companies or
trusts which can take strong positions in the investment markets and then advise
retail clients, either small companies or individuals, to invest in such vehicles. The
source of value in this operation should be found in reduction of transaction costs
and search costs. As information about the markets has become more widely
available, the gain from this operation should have declined. In fact, with the
exception of the capacity to reduced risk (which is discussed further below), the
research evidence for the creation of value by this operation is at best weak.
Professional companies and institutions do not unequivocally add value in allocating
investment funds.

More obviously, the collection function has been a creative force in financing since it
substitutes for a market not yet operating efficiently. The traditional building society
collected small amounts of savings from individuals and lent larger amounts to
home-buyers. The issue of over-the-counter securities can be seen as a special case of
this function since the financial institution provides financing by issuing a security
that can be sold to a number of investors. Instead of a market, the issuing institution
has to establish the security’s value by following a recognised procedure: validating
the issue by using the investing institution’s own name, obtaining independent audit
or accreditation via, say, a rating agency, and ensuring that there is some liquidity or
long-term exit strategy for investors. There has been an enormous growth in the
issue of securitised loans and other hybrid securities in the last decade, some of
which has been fuelled by a demand for products which it would not have been
possible, through regulatory or legal constrains, to issue in formal capital markets. In
creating value through the collection function, there will usually be a substantial
amount of repackaging by which the issuing institution will create a clientele-
orientated supply of assets to maximise the financial value of the original borrower.

Overwhelmingly, the demand in real estate financing is for assets that have the
highest rating for safety and liquidity and so value is created by redistributing and
reinsuring the credit risk of the issue through operation in the derivative markets.

Risk Transformation – diversification

Valuation of properties predominantly reflects the risk attached to each property as a
freestanding asset. So the risk in a short leasehold, for example, is perceived by
valuers as being very high because if the tenant defaults and the property is left
unoccupied, the loss in income may represent a high proportion of the cash flows
expected from the original transaction. This risk is reflected in the premium that
investors require in order to be persuaded to buy the short lease as an investment
asset. However, if the short lease is part of a larger portfolio of similar properties, the
uncertainty of income is much reduced. In effect the larger the portfolio, the more
certain are investors that an expected number of properties are non-performing with
a consequential increase in the predictability of income from the proportion of
properties that are performing. The risk of the returns from the portfolio is therefore

much lower, and the valuation of the income received from the whole portfolio
should reflect the lower risk and therefore a lower required return. In such cases, the
value of the portfolio is higher than the sum of the valuations of each component of
the portfolio.

This principle underlies some of the more innovative asset-backed securities issued
in recent years and clearly will continue to create financial value as long as the
valuation of the components reflects the total risk attached to single property
interests. We can see little change in the valuation practices of surveyors or, indeed,
in the property market as a whole that will move the valuation of individual
properties into a portfolio framework. Therefore it follows that portfolio-based asset-
backed securitisation will continue to provide added value to companies that hold
well diversified portfolios of property interests (or to issuers who can form such a
portfolio from groups of companies or institutions).

What place has financial innovation in creating value?

Realisation of unsatisfied demand.

There will always be scope for exploiting untapped demand for new financial
products. In retail investment over the past two decades, we have seen the
introduction of index tracker funds, guaranteed growth funds and hedge funds. All
are new products providing returns to innovators. But all new products, if
successful, stimulate competition and eventually, unless innovation is built into a
company’s culture, competitors catch up and reduce the “economic rent” earned by
the innovating company. Similarly products that are introduced in response to a
perceived demand during one phase of capital markets behaviour may turn out to be
unsatisfactory during another market regime.

Arbitrage between markets

A simple example of arbitrage between markets can be found in observing the
difference between rates of interest in different countries. In this instance, the
arbitrage is universally recognised. It follows that lower rates of interest in one
country will always reflect the relationship between interest rates and the spot and
forward exchange rates of the respective currencies. One can measure the
opportunities for arbitrage in currency markets in seconds or minutes so efficient
have the arbitrage-market participants become in these markets.

However in other less efficient markets, where trading is thin and liquidity is poor,
arbitrage opportunities may persist for longer periods and, in fact, may never be
resolved because of institutional constraints. In the real estate sector, there have been
numerous examples of arbitrage opportunities and some of these have been
incorporated into financing vehicles by the financial institutions.

The most visible discrepancy in the stock market is the relationship between the
assets (net of debt) held by investment property companies and the market value of
the equity in such companies. There are a few companies – Workspace, for example -
whose shares trade at an aggregate value equal to or even above the net value of the
assets held by the company, but where the normal relationship is a discount in the
stock market of 20%-25% on the value of the properties held by the company. Much
research has been carried out on possible reasons for this discount (see Barkham and
Ward, 1999) but no explanation has satisfactorily defined a way, other than
liquidation, in which the discount might be eliminated. Recent transactions that have
taken listed properties private have tended to close the discount to NAV, however.

Another obvious anomaly, which is related to the property company factor, is the
relationship between the behaviour of returns when investors invest in real estate
through the stock market and the returns derived from investing directly in the
property market. Again, there has been much ingenuity used in deriving
relationships that will explain the relationship between the volatility of property
market and stock market returns but other than concluding a long-term convergence
once gearing/leverage and appraisal-based smoothing has been eliminated, there is
little evidence of a correction in the short term that will spur arbitrage investment.

Within the debt-equivalence of the property market, there was observed to be an
arbitrage opportunity that arose with over-rented properties in the early 1990s. Over-
renting described the position reached in a depressed property market with
properties that had been previously let on a standard institutional long lease with
upward-only rent reviews. In such cases, the rent when established some years
before was much higher than the rent that might be agreed as appropriate for such
properties. The tenant therefore was committed for a long period of time to pay a
rent that could not be adjusted lower. The landlord, on the other hand, could not
reasonably expect any increase in the rent receivable because the market rent would
not be expected to overtake the rent already being paid. Sharp observation by some
investors recognised that the resulting investment effectively provided a bond-like
investment that would be attractive to bond investors. Thus these properties, which
in the early years reflected the UK perspective that such a property, by providing no
growth prospects, was an unattractive investment, developed into highly marketable
assets that were bought by, inter alia , German banks that specifically targeted the
characteristics that made the investment unpopular to traditional UK investment

More arbitrage action resulted in the recognition that the components of income from
such leases could be stripped out and repackaged to create bond- and equity-type
investments. The current position is a huge surge in activity on the part of
investment banks seeking to create further variations on repackaging that also
exploits differences in yields between the property and the bond markets.

One outcome of this arbitrage operation has been to find ways in which a lease can
be made to secure a greater amount of financing. In the case of corporate bonds,

there may be a well-established relationship between the initial value of the issued
bond and the value of the assets on which the bond is secured. Once the emphasis in
financing has changed to income rather than asset value, there is further scope for
financing. In some cases, future income may be used to enhance the credit rating of
the security. In others, the residual value of properties at the end of the lease may
also be used to underpin the current status of the debt. We believe that some of these
methods of enhancement may be sensitive to market sentiment and we are therefore
sceptical regarding the permanent establishment of higher levels of credit
enhancement derived from expectations of deferred income or capital value.

Derivatives markets

Financial innovation in the property markets has been facilitated by a continuing
growth in the use of derivatives. Commonly in the course of our interviews we
found examples of risk management in which characteristics of securities could be
altered by the investment institution taking a position in derivatives to protect
against unanticipated changes in the markets, either real or capital. A common
provision in securitising assets is the requirement of the bond issuer to protect
against adverse changes in rates of interest. Thus the original borrower may be
required to buy a cap on interest rates so that in a period in which interest rates are
rising yet in which rents are depressed, the potential shortfall in landlord’s income
could be off-loaded by means of an insurance-like position in derivatives.

There has been an enormous expansion of derivative-based vehicles. Saunders (2000)
reports that US commercial banks increased their use of off-balance sheet purchase
and sale of options on interest rates by a factor of five between 1991 and 1997 and
since then the expansion has continued at a similar rate.


This chapter has discussed the possible sources of value through financial
engineering. Although it is argued that the financial markets are, by and large,
efficient in pricing and valuing assets, there have been specific instances in which
institutions and firms have introduced new products and thereby achieved high
profits. First and foremost, imaginative financial engineering can create new
products that appeal to different investors. Financial securities can be marketed like
any other product and knowledgeable financial institutions can exploit their superior
market knowledge to tailor new packages for distinct investor clienteles. Similarly,
as argued earlier, the real estate financing market has been characterised by some
segmentation and separation from the other financial markets and financial
institutions have been quick to move in and exploit anomalies and/or arbitrage
opportunities. Finally the recognition of newer models of asset pricing has enabled
more sophistication in creating new financial instruments. In discussing the sources
of innovative value, we have noted some of the false claims that have been made.


In this chapter, we use the theoretical insights from the previous chapter to evaluate
the benefits of some of the recent innovative products and transactions in the UK real
estate market. We seek to identify any sources of added value and to explore
whether those sources are time-limited, specific to a particular company or set of
market conditions, or have a more general applicability. The starting position for our
analysis is that, in an efficient market, there will be little or no scope for adding value
at no cost with only winners and no losers. We investigate how risk and return are
reapportioned in a transaction. If it appears that both investors and the issuing
company appear to gain absolutely, we then seek to identify the source of market
inefficiency that the new product is correcting and/or exploiting.

We would stress that we are concerned with particular types of product and
transaction, rather than individual, named transactions themselves. It is not our
intention to criticise or cast doubt on particular deals which will have been carefully
structured and analysed. Rather, we wish to establish an analytic framework within
which claims can be evaluated and the value of products be assessed. An individual
deal may be successful because it deals with a set of specific corporate circumstances
embedded within a particular market environment. That same structure may be
entirely inappropriate for other firms or market conditions. Furthermore, we wish to
explore the wider, market impacts of the new products. Some products, while
introducing flexibility at one point in the market, may create inflexibility elsewhere.
This is an important consideration in framing policy responses to the demand for
new products or changes in tax or regulatory positions.

The evaluations here are at a conceptual, level rather than based on detailed
empirical analysis. The empirical validation of the ideas and hypotheses set out here
is an important future task. Where appropriate, we indicate the type of analysis

We start our analysis with asset-backed securities such as those issued on behalf of
British Land and Canary Wharf group. The discussion then extends to a
consideration of further ways of repackaging income and to pooled or conduit-based
mortgage-backed securities. Finally, we consider innovative sale and leaseback
schemes and other procurement models.

Asset-backed Securities

The claim for asset-backed securities, secured on the rental income stream and
capital values of a property company’s real estate portfolio, is that the firm can
reduce the cost of its borrowing, since the bonds/notes are rated taking into account
the covenant of the tenants. Since these may have a credit rating higher than that of
the property company, the return required by investors is lower than with a bond
secured on the assets alone. Investors are able to gain exposure to an asset that

derives its risk-return characteristics from the property market at relatively low cost
and receive a rate of interest that may be slightly above equivalent-rated corporate
bonds. The process of securitisation means that no investor carries a high exposure to
a single asset or borrower, which would not be the case for a conventional bank loan.
Finally, the process of securitisation allows the property company to access investors
and the capital markets that were previously unavailable.

Some of these claims have a clear validity. The process of securitisation permits the
risk of the transaction to be spread amongst many investors while the relatively low
cost of each security permits investors to hold the assets within a diversified
portfolio. Investors who would have faced market entry barriers can now gain
exposure to the property lending market (if they so desire!), leading to an integration
across capital values. Since these investors do not require any premium to account
for the large size of the loan, there may be downward pressure on interest rates in
the less segmented market. The same argument would, of course, apply to a
traditional bank lender securitising the loan, either individually or as part of a pool.
Securitisation is an option which reduces the required risk premium. The bank may
be able to make profits through its brokerage/intermediation role as is, of course, the
case with the investment banks who arrange asset-backed securitisation deals.

Other claims seem more debatable. One key argument is that the required coupon on
the securities is lower since it is assessed on the credit rating of the tenants, not the
property company. As a result, the proceeds of this cheaper debt are used to retire
more expensive, unsecured debt, resulting in a fall in the weighted cost of debt. In
the Broadgate securitisation, for example, it was reported that British Land reduced
their overall cost of debt by 150 basis points. However, care needs to be taken in
assessing such claims.

For the property company, existing debt – particularly fixed rate loans – has a set
payment profile. Thus, an unsecured bond with a coupon rate of 12% requires
interest payments of 12% whatever changes are made to the underlying risk of the
firm’s operations. However, in the secondary market, the price of the bonds will
change depending on attitudes to the risk-return profile of the company. The market
value of the debt will thus change. It is the market value of the debt, added to the
market value of the equity, that determines the value of the company. If a company’s
debt is perceived as more risky, then bond prices will fall, effectively increasing the
company’s cost of debt.

This suggests a more cautious interpretation. Bonds that were secured on the
company as a whole should have been assessed on the basis of the quality of the
overall rental cashflow to cover interest rates and on the value of the properties as
security in the event of default and for redemption at maturity. An asset-backed
securitisation, in effect, ring-fences certain quality properties through first charge
mortgages and subsidiary structures. This must diminish the quality of the remaining
corporate cashflow unless and until the proceeds of the securitisation are used to
acquire comparable quality assets. Thus, one might expect that the price of earlier

debt instruments in the secondary market would fall, reducing the market value of
the debt. This is a testable proposition.

Debts that are not traded on a secondary market – straight bank debt or multiple
option facilities – are not subject to such price shifts (theoretically the asset value of
the lender may shift downwards, but this may not be observable)24 . The impact of the
securitisation would be experienced when the firm needed refinancing. This would
equally be true for refinancing of bonds, paper and debentures.

The foregoing suggests that care should be taken in interpreting an apparent
reduction in the cost of debt. It is feasible that the quality of the rental income and the
security afforded by the assets in the securitisation had not been fully recognised by
the market prior to the issue. The company’s added value from the reduced cost of
borrowing would, thus, result from improved information and ease of monitoring.
However, this would imply either that the valuation of the underlying properties did
not reflect full information, a proposition that is important in arguments concerning
repackaging of rental income streams, or that the market did not trust the valuations
due to uncertainty and prior bad experience25 . Overall, if the assets and operational
practices of the company or group are unchanged, it is hard to make a case for a
permanent and significant reduction in the overall cost of debt in the absence of
persistent market inefficiencies.

Another explanation for the reduced cost of borrowing is that the securitisation
results in a change in the maturity of debt: that the issuance of bonds extends the
maturity. If this is the case, then the success of the issue in reducing the weighted
average cost of borrowing (and hence, increasing, the value of the firm) relies on two
factors: the shape of the yield curve and the length and terms of UK leases.

As noted in the previous chapter, the current shape of the yield curve, with lower
rates at the long end than the short, is unusual in an historical context. In part, it
relates to the lack of new UK government issues as the public deficit was reduced,
allied to the Pensions Act/Minimum Funding Requirement obligation on pension
funds to match their long liabilities. The result is that even though spreads are wider
at longer maturities, the coupon rates on long-dated corporate bonds are, in relative
terms, cheap. Thus asset-backed property securitisation offers, particularly where
highly rated and backed by quality covenants, are likely to find a ready market. Even
if there is a risk premium for property lending over comparable corporate bonds, the
required rates will be less than those for conventional property borrowing.

24   There is research evidence that property market events do have an impact on the market
     capitalisation of banks, proportional to their exposure to the market. For example, the share
     prices of banks exposed to Olympia & York fell in response to its troubles; contagion effects
     then reduced the share prices of other banks with substantial property loan books (see
     Ghosh et al. (1994, 1997), Cole & Fenn (1996).
25   This is a variant on Akerloff’s (1970) proposition on adverse selection, information
     uncertainty and second hand markets.

To achieve the high rated long maturities, UK issues make great play of the security
provided by the institutional lease. The long length, the upward-only rent review
clause, the fact that rent is a prior claim on company assets, all provide greater
security, encouraging AAA ratings for the senior classes. In a number of issues, there
are obligations placed on the issuer/property company to ensure that any re-lets or
assignments are on similar, institutional terms (this is true of Broadgate and the
Trafford Centre). Thus, in creating funding flexibility, the conditions may help to
preserve inflexibility in the occupational market. From the opposite perspective,
moves to introduce much more flexible occupational terms, shorter leases, break
clauses and innovative rent fixing arrangements may mitigate against the success of
future asset-backed securitisation.

Two further points are worth noting. First, it has been argued that asset-backed
securitisation enables a property company to raise more debt on assets due to more
generous loan to value ratios. The overall impact on the firm needs to be considered
here. The interest payments do represent a tax shield, but the greater proportion of
debt should lead shareholders to demand higher returns on equity to compensate for
the greater induced volatility. The overall impact on the market value of the firm
may be broadly neutral. Second, the securitisation may place constraints on the
operation of the firm. In particular, it may be difficult to dispose of those properties
allocated as security or to change their use: most of the schemes studied included
some substitution rights, but the particular nature of the properties acting as security
would make this difficult to implement. The ability to overcome this induced
inflexibility depends upon the prepayment clauses in the issue. The presence of
Spens clauses26 or equivalent penalty terms can make early redemption extremely
expensive. Given the pressure on property companies to reposition and respond to
rapidly changing markets, this constraint on activity is a significant problem.
Another consideration is that some of the asset-backed securitisations defer risk into
the future but do not eliminate risk issues.

The Value of Income and the Value of Property

One argument advocated for the value-added potential of securitisation is that the
real estate market has failed to recognise the full investment worth of properties let
on long leases. Asset-backed securitisation, in isolating one element of the income
stream, exploits this mispricing. More generally, any such pricing inefficiencies could
be exploited by repackaging the cashflows from an investment property, selling
different elements to distinct groups of investors. This could be through the creation
of income strips, swaps or through securitisation. Similar arrangements could be
made to release the value of corporate real estate as part of an innovative sale and
leaseback or outsourcing scheme.

26   A Spens clause forces an issuer, wishing to prepay a debt issue, to value the remaining
     cashflow at a very low discount rate, often the redemption yield on an equivalent maturity
     government gilt. See Catalano (2001) for examples.

The essence of such schemes is that the cashflow from a property can be viewed as
having three distinct elements. The first is the base rent or rent passing. Given a good
covenant tenant, this element is essentially a secure income stream which should be
valued at a bond market rate of return27 . The second element is the rental income
above the base rent which may arrive from the next rent review. Since the amount of
this cashflow is unknown and adverse market conditions may mean that the income
stream does not arrive until a later review (or never arrives), such an asset will attract
a different type of investor and will be valued with a higher yield. Finally, the
property will have a residual capital value at the end of the lease, a still more
speculative investment. The argument is that, since these elements will attract
different investors with different risk aversions, liabilities and expectations, the sum
of the separate elements will be greater than the valuation of the whole property.
Alternatively, it can be argued that the total amount of debt secured on the
individual elements will be greater than could be raised on the whole property28 .

The value-added elements here derive from disintermediation. The income strips can
be marketed directly to investors, since the main market for the base rent strips is
likely to be institutional. The institutional counter-argument is that these strips
would be illiquid and uncertain, but there is no real difference to a corporate bond
portfolio, which generally is only traded at the margin. It was suggested in
interviews that a strip should trade better than a corporate bond since it has the
advantage that the building can be re-let in the event of default, security increases as
the rent grows and rent is a prior claim to coupon and hence is better quality income.
However, illiquidity and the uncertainty of a new product with no market hamper
acceptance. Strips would probably be sold at a portfolio level but could be at
individual property level or even on property loans. This would most likely be a
private placement into the institutional market, pointing to a brokerage role in
introducing buyers to sellers. As with any non-standard product, the costs of
structuring such deals and legal fees tend to be high. As a market reaches a critical
mass, so scale economies drive down these initial costs.

As with asset-backed securities, it is worth noting that the potential for a market in
stripped income in the form described above is dependent upon the preservation of
the existing UK lease structure. Lease lengths must be sufficient to provide a long
maturity for the vehicle, while the upward-only rent review is needed to secure the
bond-like quality of the base tranche. Further, if the market became widespread, it
seems likely that the valuation of properties would adjust upwards to the sum of the
separated elements to eliminate arbitrage profits. This suggests that the potential to
profit from such schemes may be time-limited. However, past experience of “mis-
valuation” suggests that there is considerable inertia in the property market (and the
valuation process) such that opportunities may persist for some time.

27   Given the claims made for income stripping, it is perhaps ironic that this is, essentially, the
     assumption underlying the traditional layer method of valuing reversionary freeholds.
28   It has been suggested that this is due to a failure to account for the option value implicit in
     the upward only rent review.

Mortgage-backed Securities

The capital market benefits of commercial mortgage-backed securities have been
much discussed in the literature29 . For the originating lender, CMBS allow active
management of a loan book, adjusting exposure to the overall sector or segments of
the sector. This may be important in relation to regulatory frameworks (capital
adequacy or solvency ratio requirements under the Basle Accord or national banking
requirements), a factor that has been important in mainland Europe, if less
significant in the UK. The issuance of securities allows the originating bank to tap
new sources of capital and reduces reliance on traditional sources of short-term
deposits. Finally, the mediation role may generate value in the form of a spread
between the interest charged to borrowers and the coupon paid to investors.

This spread in turn results from risk diversification, both from the securitisation
process itself which spreads risk from one lender to many, and from diversification
across loans when mortgages are pooled or passed through a conduit vehicle. The
originating bank could (should) diversify its own loan book, of course, but carries the
whole risk of individual loans. Investors can gain access to a particular part of the
market previously subject to entry barriers with low transaction and information
costs (the monitoring role performed by the rating agency), manage their portfolios
actively and, at least in principle, benefit from liquidity in the secondary market.

A number of market implications follow from the establishment of a broad and deep
CMBS market. Capital flows into real estate should be more even than under the
traditional system due to the closer integration of capital markets, diversification
effects and new sources of capital. This should prevent capital famines during which
viable projects and firms may be unable to borrow but may also limit over-lending
due to monitoring by rating agencies and price signalling in the secondary market. In
turn, this may help to reduce the amplitude of the property cycle, particularly
allowing developers to start schemes in market troughs which arrive when demand
recovers hence damping rental growth pressures.

It has been suggested that interest rates should be lower since originating lenders are
aware of the possibility of securitising, hence requiring a lower risk premium, and
due to removal of market segmentation30 and that loans should be easier to obtain.
This last point is highly debatable. There is some contrary evidence31 that
underwriting for mortgage securitisation is more conservative than for whole loan
portfolio lending while rating agencies set exacting standards. A bank that attempts

29   Reviews can be found in Geltner & Miller (2001), Fabozzi & Jacobs (1999).
30   In the US residential markets, Kolari et al. (1998) estimate that for every 10% increase in
     mortgage securitisation as a proportion of origination, there is a decrease in the spread on
     home loans of some 20bp. In similar vein, Goebel & Ma (1993) find that integration
     between mortgage and general interest rates follows the development of secondary
     mortgage markets in the 1980s.
31   For example Terry (2000).

to season mortgage pools with high risk loans is likely to find it difficult to obtain
strong ratings for subsequent issues. Should excess capital flow into real estate, this
would, of course, reduce capital values which, in turn, would act as a brake on

These points apply to the securitisation of pools of performing loans. The 1990s saw
the development of a European market for securities backed by non-performing
loans resulting from the cyclical market downturns. Such offerings, generally at high
yields and heavily over-collateralised, provide an exit strategy for originating
lenders, help restore capital ratios and provide a speculative investment asset.
Whether they have long run impacts on market structure and stability is debatable.

Innovative Sale and Leaseback Schemes and Outsourcing

The two high profile innovative sale and lease back schemes discussed above – the
Sainsbury’s and Abbey National schemes – are quite different in structure. However,
a number of common points emerge from such schemes. As noted in the previous
chapter, available research suggests that leasing does not add value per se. Any
added value, then, must result from mispricing, in which case there are losers as well
as winners, from information effects or from alignment of interests.

In the Sainsbury’s deal, the firm was able to raise £328million net from the sale which
it could apply to operations, allowing a focus on core business. With the assets sold,
the rent appears explicitly as a cost in the accounts allowing investors to assess
returns relative to factor inputs. Furthermore, the indexed rents creates greater
certainty in cashflow, although the residual position is uncertain with the firm
having the option to repurchase at some uncertain capital value, renew or dispose of
the properties and the responsibility of meeting any redemption shortfalls (which
may bring the deal back on balance sheet). It is claimed that the cost to Sainsbury’s of
raising the money is just over 7%, although the pure cashflow internal rate of return
is closer to 8.25%. In either case this is cheaper than conventional funding. The rental
payments generate a tax shield effect and there is potential for a share of any capital

The cost for Sainsbury’s relates to the terms of the leaseback. Although there are
substitution and redevelopment clauses subject to valuation diminution tests,
Sainsbury’s has committed to 23-year terms which are necessary to provide the long
maturity for the bonds issued to be marketable, to part-amortise the debt and to
carry a low enough coupon to justify the deal. There has thus been an arms-length
maturity transformation and constraints placed on the activity of the retailer. The
indexed rent provides stability and certainty and, at a discount rate of 10%, translates
to an average growth rate of around 1.7% on a conventional lease with five year
reviews. This is certainly lower than the average rental growth of supermarkets over
the last ten years as measured by IPD. Even with the constraints in the deal, the
terms of Project Redwing are much more favourable than those of a conventional

sale and leaseback, with the typical tenancy being long and with upward-only
reviews to market rent.

The Abbey National divestiture is quite different in structure. In transferring
freehold and leasehold assets to Mapeley, the bank sought to maximise its
occupational flexibility, with rights to surrender properties, extend leases and buy
back freeholds, with a much shorter average lease length. However, the deal appears
to be costly. It is hard to assess the overall cost of the leaseback, due to the
assignment of lease responsibilities. The initial rent roll of £80million represents
17.5% of the £457million released. Equally, the 3% indexation of the rents is
equivalent to nearly 4% per annum for a five yearly review cycle, again using a 10%
discount rate. While this is close to the average for the second half of the 1990s, it is
higher than the long run average, and at a time of low inflation represents high real
growth. Nonetheless, Abbey National has raised capital from its corporate real estate
portfolio, bought flexibility and made the cost of its real estate inputs explicit for
shareholders32 .

The sale and leaseback arrangement that Shell entered into with Rotch and London
& Regional in 1999 appears to occupy an intermediate position between the
Sainsbury and Abbey National deals. As noted above, Shell sold 180 filling stations
to the joint venture, taking the assets off balance sheet, and raised £300million. It took
long, 18-year leases with apparently stiff rent review clauses, upward-only to the
higher of market rent or 2.5% per annum compound growth. This enabled the joint
venture to raise 90% of the capital in a fully amortizing loan. However, Shell can
assign any of the stations, swap sites in and out of the portfolio subject to value
checks, and withdraw obsolete sites. This creates risk for the owner but also creates
potential opportunities for reletting or redevelopment.

It thus seems that the amount raised via sale and leasebacks and other outsourcing,
and the cost of that capital, is in inverse proportion to the amount of operational
flexibility obtained. In particular, innovative sale and leasebacks that produce cheap
capital tend to be accompanied by long term commitments, representing both a
maturity shift and a constraint to operational flexibility. This must be considered in
evaluating the benefits of such schemes. The hidden costs of constraints on active
asset management and operational decision making should not be neglected.

US research on the impact of corporate real estate management on firm value
suggests that moves that improve transparency result in increases in firm value33 . In
particular, evidence suggests that real estate sell offs are associated with increases in
wealth (the market value of the firm). It is argued that the sell-off provides true
information about real estate values and property costs (recall that much corporate
property is held at historic cost). The evidence on sale and leaseback is less clear. The
positive impacts identified include raising capital at a cost below that of a

32   That Abbey National was subject to takeover bids clearly had some influence on the deal.
33   Reviewed in Rodriguez & Sirmans (1996).

conventional sale and leaseback and at an amount greater than a conventional
secured loan. Other gains relate to improvements in tax position. However, in a
number of the examples, there are quite high costs involved in terms of corporate
flexibility which may offset any improvements in company value. By contrast, the
creation of a corporate real estate vehicle and its spin-off into a separate entity
appears strongly associated with wealth gains for stockholders. It thus seems that
moves that make explicit the value of property and the impact of real estate
management provide valuable information to shareholders and signal an intention to
maximise wealth. This information, together with any tax gain, is capitalised into
share prices, increasing the value of the firm.

Summary: Innovation and Added Value

The foregoing suggests that a number of the innovative schemes in the UK do not
offer the unequivocal benefits claimed, nor do they offer a long term panacea for the
inflexibilities of the traditional market. This is not a criticism of any single scheme.
Most have been imaginatively structured to meet the needs of particular clients and
to exploit particular market conditions. Where the innovations exploit arbitrage
opportunities and market inefficiencies, they contribute to greater market
transparency, liquidity and efficiency and, in certain instances, can increase firm
value and wealth.

However, as the analysis shows, value gains in one area may be offset by costs in
another, and flexibility in one area may be offset by induced inflexibility elsewhere.
In assessing the benefits of particular vehicles and schemes, it is important that all
the implications are traced through. This is particularly true of the tension between
business demands for flexibility in the occupational market and the development of
asset-backed securitisation which aims to extract full value from the proper
assessment of the risk-return characteristics of different elements of rental cashflow.
Many of the highly rated asset-backed securitisation structures are predicated on
lengthy standardised leases and contain restrictive clauses preserving such

Schemes that rely on unusual market conditions may be “period pieces” and have
less long-term impact on market efficiency than those that address structural
constraints such as market segmentation, information asymmetry and market entry
barriers. The current shape of the yield curve is unusual in an historic context, a
function of the lack of long government fixed interest securities and the relative
immaturity of many pension schemes. As pension schemes mature, and seek shorter
dated bonds, and if the public sector borrowing requirement increases and is funded
by longer dated issues, then the yield curve may return to its historic shape,
increasing the cost of long-term money and threatening the rationale for new asset-
backed securitisation in the current format.

The increase in the size of the property-securities market reflects both demand and
supply. On the demand side, there is a strong requirement for long-term bonds

which creates a product demand and leads to required returns which make the
schemes feasible even in the face of competition from the Pfandbriefe-funded
German mortgage banks. The supply side is important too. When there are few
issues, their non-standard nature, the complexity of analysis and uncertainty over
the market act as a disincentive for investors. As the market grows, there are
economies of scale, greater experience of the operation and potential of schemes, and
more confidence in the characteristics of the cashflow. This, in turn, helps to secure a
liquid secondary market. Once a critical mass has been achieved, growth can be self-
sustaining. This was very much the US experience: London interviews saw a similar
trend in European markets, constrained slightly by national barriers.

 We have not explicitly treated tax issues in this report. Nonetheless, these are very
important since many schemes rely on tax efficiency to make value gains. This merits
further research. We highlight two important aspects. First, tax and accounting
positions vary considerably across national jurisdictions. This means, for example,
that schemes that are of benefit in the US will not necessarily be successful in the UK.
Second, in the current UK market, many schemes are driven by the tax status of the
different players, in particular tax-exempt institutional investors and corporations
who seek tax shields to set against profits. The current position may be subject to
review particularly with the growth of tax-exempt private savings schemes.


This study has reviewed examples of real estate finance and funding in the UK in the
light of suggestions that the UK property market has lagged behind North American
practice. At first sight, the case that such a lag exists might appear plausible: the
dominance of traditional institutional practices and conservatism still continues in
the UK, enshrined in attitudes such as a strong preference for long leases and
upward-only rent reviews. There is ample evidence that UK property market
professionals are still influenced by a nostalgic regard for fully-let, 25-year leases
buttressed by expectations of continual nominal rental growth and by an inherent
distrust of non-normal patterns of rental cash flows. The resultant valuation and
legal inertia can make it difficult to establish innovative vehicles and practices.

Notwithstanding the suspicion of innate hostility to innovation, the inferences that
can be drawn from our study are optimistic. Driven by the expansionary market
conditions in the 1980s and toughened by the market slump in the early 1990s, a
breed of finance-led property professionals have emerged in the UK, less influenced
by the “all-risk yield” than by a concern for total returns and cashflow-generated
performance. The outstanding reputation of firms and individuals in the City of
London as initiators, entrepreneurs and financial engineers is well exemplified
within the ranks of those involved in real estate finance and funding.

In our study, we interviewed staff from investment banks, rating agencies,
corporations, institutional investors, property companies, property consultants and
agents. In order to preserve commercial confidentiality we have not generally
ascribed information provided to the individual respondents. Nevertheless, we are
grateful for the generous supply of time and open, helpful attitude of those whom
we approached. From those interviews and from the evidence of the wider research
project, it is evident that the level of sophistication in analysis and technique has
developed considerably in recent years.

In this report, we have not dwelled on the inhibitions imposed by the institutional
form of the UK occupational property market, since it has attracted considerable
criticism elsewhere. It is well recognised that the upward-only rent review clause
benefits the landlord in rising markets but prevents the tenant from taking
advantage of any falls in market prices. The professionally-trained surveyor may
have failed to recognise that non-standard leases were mispriced but, historically,
there is evidence of some property investors exploiting mispriced asset classes. In a
market system, one has to rely on the performance of efficient investors becoming
sufficiently well-known that market behaviour is affected if one is to maintain faith
that the best investors will come to dominate the worst. The cyclical nature of the
property market might have disguised the inevitable force of competition for a while
but the shocks of the late 1980s and early 1990s provided a salutary lesson for
property investors and ultimately created opportunities for finance-led innovation
which are still being exploited currently.

Just as there has been some integration of the professional decision making in the
property, equity and bond markets, so has research mirrored the parallel
development of capital markets. We briefly reviewed studies that have explored
linkages between the markets for occupational property, investment property and
securities. The linkages are not always easy to unravel and, in some cases, statistical
ingenuity seems to dominate economic plausibility. But the connections between, for
example, the market capitalisation of UK corporations and the estimated value of
property owned by those corporations, is a healthy reminder that forward-looking
capital markets provide information to property investment and financial decision-
makers as well as to equity or bond investors.

Property is an asset that can be used to secure finance and funding in a huge range of
forms. Prior to the 1990s, finance and funding of real estate was segmented from
other parts of the capital market. In the market environment that then existed,
conservative lending rules restricted the ability of firms to raise capital, a restriction
that applied to corporations as much as specialist property companies. As the
awareness of innovation in the bond market increased on the part of those concerned
in real estate finance, so did the ideas proposed for creating similar vehicles based on
asset values and, more importantly, on income generated from real estate.

The US markets, accustomed to fixed interest mortgages, first developed commercial
mortgage-backed securities, modelled on the success of residential mortgage-backed
securities, with the asset-backed market following in the late 1980s. After a slow start
in the UK, similar markets are developing for both residential and commercial
mortgages. The comparison between new securities based on bundling or separating
income flows and traditional corporate bonds secured on specific or general assets is
widely recognised and the comparative costs of issue, servicing and rating are
closely monitored by the investment banks, acting as primary brokers for security
issues and their corporate clients alike.

There have been innovatory efforts in the UK that have been tried but, for reasons of
inappropriate timing or market sentiment, have failed. Property-related derivatives,
for example, have not yet developed in the way that might have been hoped for. If
capital markets are to be effective, investors should have ways of adjusting their
exposure to risk. Derivatives have become the primary way in which this risk
adjustment has been developed in commodities, securities, interest rates and even
arcane areas such as weather and insurance products. The lack of a successful
property-related derivative is a significant factor inhibiting the development of
effective markets in real estate finance but it is one which is common to both the US
and UK and, arguably, one in which more effort has been expended in London than
any other financial centre. The inherent information difficulties of direct real estate,
with its infrequent performance indices based on valuations rather than transactions,
act to constrain the development of a property derivatives market. The growth of
property-related securities traded in the capital markets thus offers hope of a higher
frequency, transaction-based data series that can be used to develop new derivative

products. In turn, these would allow investors to hedge and adjust their exposure to
property markets in an efficient and cost-effective manner.

This informational aspect of innovation in property markets is important. Not only
have finance and funding been segmented from the capital markets, so too have
property analytic techniques. The growth of a publicly-traded, securitised market in
real estate products creates a capital market discipline that should serve to ensure
that new information is swiftly incorporated into property prices. It will be
interesting to observe the extent to which specific individual commercial property
valuations in the direct market are influenced by movements in the indirect market.
For such impacts to occur, the size of the securitised market must reach a critical
mass in relation to the size of the underlying property market. It may be that a two-
tiered market will emerge between prime properties, however redefined, that are
suitable for securitisation and non-prime properties that remain distinct from the
more integrated capital market environment.

In terms of critical mass, it seems evident that the mortgage- and asset-backed
securities markets have reached a sufficient size for economies of scale and
standardisation to begin to occur. While deals are infrequent, customised and
innovative, cost structures are high and potential investors face uncertainty. This is
important in a European context, where conventional lending margins have
generally been tighter than in the US. Familiarity with product, historical
performance data and growing liquidity ensure that costs are lower and that
required returns are less, enhancing the viability of schemes. This in turn creates
further demand for product and further supply. We believe that there is evidence
that this virtuous circle is in place.

The fiscal environment has also had its influence on the development of real estate
financial products. The comparison of the UK and US tax systems reveals an obvious
advantage in the US that allowed the creation of tax-transparent companies (REITs).
Despite considerable efforts in the UK, no general vehicle has been developed
although an illiquid equivalent - the limited partnership - can achieve some of the
features obtained by the REIT route. Although from time to time sympathy towards
the idea of a tax- transparent real estate investment vehicle has been expressed by
official sources within the UK, the case is not sufficiently overwhelming to overcome
DTi and Treasury resistance. The recent history of the REIT industry in the US has
revealed that valuing real estate companies by reference to their current income can
provide highly volatile changes in both values and returns as investor sentiment
wanes or surges in response to forecasts and market changes.

In this report, we have discussed how businesses add value through financial
operations. By reviewing both conceptual and practical developments, we aimed to
provide potential investors with a toolbox with which they could reflect on the
potential for value in the current climate. In particular, we wanted to remind
investors that value is more difficult to create if markets are efficient and if investors
are already aware of the sources of their investment risk. We do recognise some clear

examples in which the entrepreneurial talent of investment bankers and institutional
investors can exploit gaps or lacunæ in the markets. Briefly these included
recognising latent demand for new financial products, such as long duration
securities to satisfy pension funding requirements, and spotting differences in the
valuation of similar financial products in more than one market - market arbitrage. In
the absence of a properly functioning capital market, institutions can also exploit
their position of knowledge by acting in a brokerage capacity, supplying a
wholesaling function or transforming claims from one maturity to another.

In securitisation of real estate assets, many of the new securities are based on the
concept of ring fencing. This can enhance the investor credibility of the issue, but also
can have secondary effects on the other securities issued by the company. Another
factor that enhances the credibility of income-backed securities in the UK is the very
same institutional lease that is criticised as being inflexible and inequitable to
tenants. UK issuers make great play of the security provided by the institutional
lease and, in particular, the upward-only rent review. One possible justification for
this stance lies in the argument that the real estate market has failed to recognise the
full investment worth of properties let on long leases and the option inherent in the
rent review clause.

Finally, we would wish to express some reservations about financing schemes that
are effectively trading along the yield curve. Since long-term interest rates currently
are below short-term rates, one can arrive at apparent profitable schemes that in
‘normal’ times would simply not survive. Whilst one can applaud the
entrepreneurial ability to spot and exploit yield curve reversals, we would expect
such products not to be sustainable in the economic environmental sense.

As a corollary of this claim, schemes that address structural constraints – market
segmentation, information asymmetry and market entry barriers, for example -
might well continue to be a feature of the expanding property finance market for the
foreseeable future. These structural constraints represent a form of market
inefficiency and innovative products thus help to create a more efficient real estate
market that assists in the efficient allocation of resources in the economy.


Many individuals and firms contributed to this research. Some wished to remain
anonymous. We would like to express our thanks to all those contributors while
emphasising that the views expressed in this report are those of the authors alone.
The following is a partial list of those who contributed to the study.

Brad Baumann, CB Hillier Parker
Peter Bennett, Corporation of London
Ken Bernstein, Acadia Realty Trust
Robert Blumenthal, Deutsche Banc Alex Brown
Angus Dodd, Parkes and Company
Jamil Farooqi, JP Morgan Securities Ltd
Teresa Gilbert, Parkes and Company
Sally Gordon, Moody’s Investors Service
Peter Hansell, Standard and Poors
William Hill, Shroders
Meg Kaufman, Corporation of London
John Kriz, Moody's Investor Services
Steven Laposa, PricewaterhouseCoopers
Jerry Levy, New York University
Charles Maikish, Real Estate Business Services
George Matysiak, CB Hillier Parker
Deborah Miller, Moody’s Investors Service
Guy Morrell, Henderson Investors
Ken Patton, New York University
Robert Promisel, European Investors
Scott Robinson, Standard and Poors
James Rehlaender, European Investors
Robert Ringrose, JLL Corporate Finance Ltd.
Rosemary Scanlon, New York University
Stephen Satchell, University of Cambridge
Mark Taylor, Workspace
Emmanuel Verhoosel, JP Morgan Securities
Leslie Whatley, Real Estate Business Services

Thanks are also due to our colleagues in the Department of Land Management and
Development at the University of Reading for their support and comments: Andrew
Baum, Peter Byrne, Neil Crosby, Virginia Gibson, Pat McAllister and Scarlett Palmer.


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