Many European listed property companies appear to be more reactive than strategic in their major capital budget decisions when acquiring investment properties and undertaking development projects.

These companies are not making full use of the sophisticated analytical tools available to them, the preliminary findings of the European Public Real Estate Association’s first Capital Structure Survey indicate.

Colin Lizieri, Grosvenor Professor of Real Estate Finance at the UK’s Cambridge University and lead author of the survey, says: “We certainly formed the impression of an industry reacting to market conditions, rather than using strategic planning, and one that is not making the best use of the analytical tools available to help it with crucial capital allocation decisions. I need to stress that these are preliminary results and further analyses of the survey’s implications need to be undertaken.”

In taking investment and development decisions, the majority of firms used discounted cashflow methods. Internal rate of return was generally preferred to net present value, despite the former’s technical shortcomings. Many firms still employed ad hoc decision-making tools such as payback or income on cost ratios. There was no evidence that advanced analytic approaches using real options models, VaR or EVA were widely adopted in the European property industry.

Mainland European property firms generally used lower risk premia than UK firms; Reits used higher risk premia than non-Reits. The levels quoted by firms seem very high, suggesting that they might struggle to justify acquisitions without bullish rental growth assumptions.

Over 25 per cent of firms stated that they did not estimate their cost of equity: in turn this implies that they are either not using or not updating their weighted average cost of capital. Reits tended to use more sophisticated capital market estimation models than non-Reits.

Most firms adjusted discount rates for specific assets and projects. The factors determining that adjustment were typically at individual asset level driven by micro-location, building factors or tenant covenant. The factors typically used to structure portfolio allocations – sector and geography – were lower rated.

Most firms had some form of debt/equity ratio target: European firms typically had stricter target ranges, while UK firms had more flexible ranges or no target at all. This allows them to be more tactical and opportunistic, but also determines that they must be more reactive and vulnerable to market shifts.

By contrast, few firms appeared to have strict targets for average debt maturity. Some 27 per cent of firms (and 21 per cent of Reits) had no target at all. There was some evidence that firms preferred longer term debt, both to reduce refinancing risk and match the maturity of asset, project life and lease length.

The major factors that determined a firm’s level of debt appeared to be typically reactive rather than strategic. Some 83 per cent of firms cited loan to value and other financial covenants; 60 per cent of firms cited interest rate coverage ratios as determining debt choices; a further 40 per cent reacted to the cost of equity in the market.

The sense of an industry reacting to market conditions is confirmed by a strong preference at a project funding level for the cheapest forms of capital available at that point. About 70 per cent of non-Reits opted for the cheapest form, with just 25 per cent having a defined preference for a particular form.

There was, however, evidence of an ordered preference for forms of capital which conforms to prior general research on firms’ capital raising with a “pecking order” of, first, free cash, then sale of assets, raising new debt third and issuing new equity fourth. This held most strongly for non-Reits. The Reit situation is made more complex by required payments to shareholders and the lack of tax deductibility.

Reflecting market conditions, 75 per cent of firms had seriously considered, or had actually raised new equity; 90 per cent of Reits responding had considered new common stock issues. The reasons given were dominated by negative factors, with 70 per cent citing the need to restore the firm’s debt equity ratio.