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Gearing and the Australian real

estate investment market

Gearing and the

Australian real
estate market

Anthony J. De Francesco
Colonial First State Global Asset Management, Sydney, Australia
Abstract

579
Received July 2006
Accepted June 2007

Purpose The aim of the paper is threefold: to provide an overview of gearing in the Australian real
estate investment market; formally examine the relationship between property returns, risk and
gearing; and provide some guidance in evaluating optimal gearing levels for real estate investment.
Design/methodology/approach A mathematical modelling framework is presented for
evaluating the relationship between investment returns, risk and gearing levels.
Findings The study highlights that risk rises with rising gearing levels and that risk-adjusted
returns fall with rising gearing. Furthermore, it is shown that the gearing-risk relationship is
influenced not only by the cost of debt structure but also the interdependency between ungeared
returns and interest rates.
Research limitations/implications The study suggests that current gearing levels from
Australian listed property trusts and unlisted wholesale property funds are relatively conservative.
This implies that current gearing could be increased, in particular for wholesale funds, without taking
on substantially more risk whilst enhancing returns.
Practical implications The paper is of value to industry and academia as it offers an extended
framework for evaluating the relationship between risk and gearing. In particular, the framework
provides insight for gauging gearing levels when constructing real estate investment strategies.
Originality/value Importantly, the paper shows that the interdependency between ungeared
returns and interest rates significantly impacts the relationship between risk and gearing.
Keywords Gearing, Financial management, Real estate, Australia, Risk management
Paper type Research paper

I. Introduction
Since the early 1990s the level of debt and gearing has steadily increased, both in the
wider economy[1] and the investment market. For instance, household debt has
increased markedly mainly due to increased housing finance; with the fastest growth
for residential investment. The Reserve bank of Australia (RBA) attributes this to three
main factors: the lower interest rate environment; lower inflation; and financial
deregulation. On this latter point, increased debt is due to increased competition with
more aggressive pricing, financial intermediaries encouraging investment loans, and
the development of new products such as home-equity loans and mortgages with a
redraw facility. The listed equity market has also seen a wider use of gearing with the
proliferation of margin lending products and instalments[2] as well as an increase in
leverage by companies that previously had low levels of gearing.
Presented at the 13th European Real Estate Society (ERES) Conference, Weimar, Germany (7-10
June 2006). The author thanks Angelo De Francesco for his assistance with the paper. All errors
are the authors own.
Winner of the IPD Prize for the Best Paper in Property Investment.

Journal of Property Investment &

Finance
Vol. 25 No. 6, 2007
pp. 579-602
q Emerald Group Publishing Limited
1463-578X
DOI 10.1108/14635780710829298

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A similar phenomenon is evident in the commercial property investment market. In

particular, Australian listed property trusts (LPTs) have experienced significantly
increased levels of gearing over the last ten years. This higher gearing is used to
facilitate a wider product offering to investors along the risk-reward space. For
instance, gearing is used to deliver property products with a higher alpha or capital
growth bias (through taking on development exposure) or to assist in acquiring
property assets offshore. Accordingly, motivated by the prospect of enhancing returns,
unlisted wholesale real estate funds are also seeking to raise gearing levels. With
greater use of debt in property investment products there has been much industry
debate about the corresponding increased risk and hence, the optimal level of
gearing. This is of particular interest to investors of unlisted wholesale property
investments, (being mainly superannuation funds), where the debate regarding the
optimal gearing level necessarily focuses on the additional risk incurred by the
investment.
Gearing is a general term used to describe borrowing (or debt) within an investment
context. It refers to the use of borrowed funds to earn a return greater than the interest
paid on the debt. Gearing is usually expressed as the ratio of debt to total (gross) assets.
A related term, leverage, on the other hand, describes the degree of gearing or
borrowing.
The contribution of this paper is three-fold. First, the paper provides an overview of
gearing for the Australian real estate investment market. Notably, LPTs have taken on
significantly more gearing. Second, the paper formally examines the relationship
between property returns, risk and gearing in an attempt to better understand how
gearing impacts property performance in terms of risk and return. It is shown that the
relationship between these variables changes depending on whether the cost of finance
is fixed or variable. More importantly, it is shown that the interdependency between
ungeared returns and interest rates also significantly impacts the relationship between
risk and gearing. Third, the paper provides some guidance in evaluating optimal
gearing levels for real estate investment. It is highlighted that the concept of optimal
gearing is couched within a given investment objective.
The paper is structured as follows. Section II briefly describes the changing gearing
profile across real estate investment vehicles. Section III outlines the modelling
framework for gearing. Section IV provides some empirical results using direct
property returns. Section V provides a discussion on the concept of optimal gearing.
Section VI provides concluding remarks. Mathematical derivations are contained
within the Technical Appendix.
II. Gearing across real estate investment vehicles
There are several reasons motivating the use of gearing across real estate investment
vehicles. First, it offers a strategy for enhancing investment returns against alternative
investment strategies that may offer greater risk[3], such as taking on exposure to
lower grade real estate assets which have the potential for higher growth. Second, it
offers the ability to generate enhanced investment returns with debt being a relatively
cheap source of capital relative to equity. In other words, it may lead to a reduction in
funding cost[4]. CommSec (2002) comments that real estate (listed and unlisted) trust
managers view debt as an attractive source of cheap capital. This is generally
supported by a relatively low and benign interest rate environment, new innovative

financial instruments, and low market volatility. Third, it can lead to a tax benefit. For
instance, the use of debt has the additional advantage of interest expense being
deductible in calculating taxable income, whereas dividends on preferences and
ordinary shares are not tax deductible. This leads to increased cash flow, hence making
debt a valuable financing tool. However, this is relevant only for syndicates as the tax
argument offers no obvious attraction for LPTs and unlisted wholesale funds as they
have a tax-free status (i.e. trusts being exempt from company tax provided they
distribute all income to unit holders).
Figure 1 shows historical gearing levels for LPTs, unlisted wholesale real estate
funds and syndicates. Notably, gearing levels differ markedly across property vehicle
and over time.
Over the course of the past ten years, gearing levels for LPTs have increased from
approximately 10 percent to 40 percent. The rise in gearing has been motivated by
LPTs wanting to expand and generate enhanced returns. UBS (2004) note that the
take-on of additional debt levels has contributed to strong distribution per unit growth.
This has coincided with a gradual reduction in the level and volatility of market
interest rates as indicated by the falling ten year bond rate shown in Figure 2. As
expected, the chart clearly shows an inverse relationship between gearing levels and
the interest rate. This level of gearing for the sector seems consistent with other global
REIT markets: gearing levels for US REITs and J-REITs were approximately 45
percent and 40 percent respectively as at March 2005.
Figure 3 shows gearing levels across the LPT sub-sectors for 2003, 2004 and 2005.
While gearing has increased across all sub-sectors, it varies markedly. The sub-sectors
with the highest gearing include retail and international. The varying gearing level
across sectors can be partly explained by the stability of their income stream. For
example, the higher gearing for the retail sector over office can be justified by its more
stable cash flows, underpinned by longer contractual lease arrangements (linked to
consumer price inflation) with anchor tenants. This implicitly provides the retail sector
with some hedge against rising interest rates on the back of higher inflation. With
reference to trusts with international property exposure, a large proportion of these
assets reside in the United States (USA). Hence, borrowing higher levels of debt in US

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Figure 1.
Gearing levels across
property vehicles

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Figure 2.
AUS REIT gearing ratio
and interest rates

Figure 3.
Gearing ratios across Aus
LPT sectors

dollars provides a higher natural hedge as it reduces the risk of the investments
income and net equity.
Interestingly, while gearing has progressively risen for LPTs it has not translated
into rising equity beta values as one may have expected. This suggests that maybe the
risk of gearing is not being appropriately priced in the market or that this has been
offset by other market factors (such as a general de-risking of real estate against other
asset classes).
Gearing levels within wholesale unlisted property funds remain relatively low in
comparison to LPTs and syndicates. Most of the funds trust deeds, which represent

investors of superannuation funds, have been reluctant for the funds to carry high
levels of debt, due to concerns of introducing greater volatility in return profiles.
However, in the past few years gearing levels for Mercers unlisted wholesale funds
have risen towards 10 percent-15 percent, as shown in Figure 1.
In contrast to wholesale unlisted property funds, property syndicates carry
relatively high gearing levels, hovering around 50 percent. Despite this high gearing
level, investment into property syndicates is usually accepted by investors, induced by
the (perceived) lower cost of debt, the tax effective benefits of owning property and low
earnings volatility in property income.

III. Modelling framework

This section provides a rigorous treatment of gearing. It sets out a framework for
examining the relationship between returns, risk and gearing in an attempt to
formulate a view on optimal gearing levels. First, the basic concept of gearing is
outlined within an investment return setting with fixed cost of debt. Second, the
conceptual framework is extended by allowing the cost of debt to be variable.
Furthermore, the dependency between the cost of debt and ungeared returns is also
examined.
Basic concept
Following Rowland (1996), consider the following return expression which relates
ungeared returns to geared returns:
Rg

Ru
cL
2
1 2 L 1 2 L

where Ru is the ungeared equity return in a property asset or fund, Rg is the geared
return, c refers to the cost borrowing or finance, and L is the gearing level (defined as
the value of debt to total gross asset value or loan-to-book value expressed as a
percentage), and 1 2 L is the gearing ratio. L is restricted from taking on a value of
100 per cent as it would imply that the financier would effectively be the equity holder
of the investment.
Equation (1) states that the geared return consists of two main components. First,
the leverage component which describes how the ungeared return is adjusted to
account for the leverage effect where the total return invested rises by a reduction
in the equity base on which returns are earned. The second component describes the
cost of gearing. When the gearing level is nil (i.e. L 0), then the geared and
ungeared returns are equal (i.e. Ru Rg ). As the gearing level increases towards
one, (i.e. L ! 1), this inflates the ungeared returns, which is typically offset by a
growing gearing cost.
Furthermore, equation (1) can be simply expanded to explicitly account for income
and capital returns. By partitioning total returns into income (Ry ) and capital returns
(Rk ), equation (1) can be rewritten as:
Rg

Rk
Ry 2 cL

1 2 L 1 2 L

10

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From equation (10 ) the impact of gearing on capital and income returns is asymmetric.
This arises as the cost of gearing component is typically matched against income return.
Equation (1) highlights that there are two factors that determine the impact of
gearing: L and the difference between the ungeared return and the cost of finance.
Hence, varying Ru , c or L will result in a wide range of geared return outcomes. This
variability or risk is formally examined via the standard deviation, which is given by:



 2
1=2
1
sRg
sRu L 2 s2c
2
1 2 L
Equation (2) indicates that higher gearing leads to higher risk. Bhandari (1988) argues
that an increase in gearing of a company will increase the risk of its common equity
and hence the increased risk should be compensated by higher returns.
Basic concept fixed cost of debt
For simplicity, let us assume that the cost of gearing c depends on a fixed interest rate
denoted as c i0 . The resulting geared return and risk equations are given by:
Rg

Ru 2 i0 L
1 2 L

sRg

sRu

1 2 L

1a


2a

Furthermore, we wish to examine how these two variables change with leverage. This
is done by computing their partial derivates with respect to a change in leverage. These
are given by:

R g
Ru 2 i0

. 0 if Ru . i0
L
1 2 L2

1b

sRg
sRu

.0
L
1 2 L2

2b

Equation (1b) indicates that leverage increases return only if the cost of debt (in this
case, the interest rate) is less than the unleveraged return. Otherwise, leverage will
reduce unleveraged returns. Equation (2b) indicates that risk rises with leverage. What
is of further interest is the trade-off between geared return and geared risk. In
examining this, consider the risk-return expression given by (3a) and its derivate with
respect to leverage given by (3b):

R g
R u 2 i0

sRg
sRu

3a

Rg =sRg 2i0

,0
L
sRu

3b

and

Equation (3a) highlights a linear trade-off between return and risk on the Rg and sRg
space. Importantly, the direction of the slope depends only on the spread between the
unleveraged return and the cost of debt. When this spread is positive (Ru . i0 ) then
leverage will increase returns and conversely when the spread is negative (i0 . Ru )
undertaking leverage will reduce returns. Furthermore equation (3b) indicates that
risk-adjusted returns are falling with rising gearing. This is because the geared return
is decreasing as a proportion of risk with rising leverage.
Extensions to the basic model variable cost of debt
This section relaxes the assumption of a fixed cost of debt, allowing the cost of debt to
vary with the level of gearing. More specifically, c depends on the interest rate, which
in turn, is a function of the gearing level. This can be expressed as c f i; L ; iL.
Under this scenario the cost of borrowing or interest rate rises with higher levels of
gearing. This is expressed as i0 L . 0 where i0 Lis the first derivative with respect to
L. The modified return and risk equations are expressed as:
Rg

sRg

Ru 2 iLL
1 2 L

1c

h
i1=2
1
s2Ru L 2 s2iL
1 2 L

2c

Note that the risk expression (2c) is larger than (2a) with the additional risk element
attributable to leverage. This in turn complicates the risk-reward trade-off which is
given by:


Ru 2 iL L1 2 Li0 L
s2Ru L 2 s2iL
1=2
R g


3c

 2

sRg
s Ls2 0:51 2 LL 2 s20 
Ru

iL

i L

Equation (3c) highlights a non-linear trade-off between return and risk. In contrast to
equation (3a), the risk-return now depends on the level of leverage. The direction of the
slope depends on the spread Ru 2 iL L1 2 Li0 L
. As gearing rises, c also
increases such that the incremental positive contribution of gearing is progressively
smaller. At some point, the value of c could be large enough such that the geared return
will be lower than the ungeared return. In this case, taking on additional gearing is
clearly not feasible. The precise nature of this relationship depends on the specific
functional form given to c in case II. This is explored further in Section V. Note that
when c is independent of L, then (3c) collapses to (3a).
Extensions to the basic model dependency between ungeared returns and interest rates
So far the modelling framework has assumed that both the cost of debt and the
ungeared return are independent. However, this assumption may appear to be too
restrictive if both the cost of debt and ungeared returns are both a function of market
interest rates. For instance, a rise in interest rates will adversely affect property returns
as it will curb growth in rental income, via a softening in tenant demand, and also raise
the discount rate, via a rise in the risk-free rate. Both of these influences will lead to a
decline in the asset value of the real estate, resulting in a negative capital return. This

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interdependence between ungeared returns and the cost of gearing adds a further
dimension to the return-risk profile; one which is commonly overlooked in the property
industry when assessing the impact of gearing on portfolio risk.
Expressing ungeared returns as a linear function of the interest rate,
Ru ; Ru i a bi, the resulting geared return and risk are given by:

586

Rg

Ru i 2 iL
1 2 L

sRg

h
i1=2
1

s2Rui L 2 s2i 2 2rsRu si

1 2 L

1d

2d

where r denotes the correlation between the ungeared return and interest rate. One
would usually expect that r , 0 with returns being inversely related to a positive
movement in interest rates. In this case, (2d) suggests that risk on geared returns will
be higher. Clearly, if these two variables are uncorrelated, then r 0, and (2d)
collapses to (2). Under this scenario, the impact of an interest rate shock would not just
affect the geared return and risk variables, but also the ungeared return, magnifying
the leverage effect, either positively and negatively.
IV. Stylised results
Employing the relationships outlined in the previous section, this section examines the
impact of gearing on direct property returns for Australia. Use is made of historical
quarterly ungeared nominal total returns based on the PCA/IPD Investment
Performance Index for the period between 1985:Q4 and 2005:Q4. Annualised rolling
returns for total property and core property sectors are depicted in Figure 4. Clearly,
the series show a pronounced change around 1994/1995 with returns being relatively
stable since this period. Given that average return and risk estimates would differ
markedly pre and post 1994/1995 periods, the analysis proceeds by considering the
later sample period between 1995:Q1 and 2005:Q4.

Figure 4.
Direct property returns

Fixed cost of finance

Firstly, assuming fixed financing costs, Figure 5 shows the impact on property returns
with increasing levels of gearing. The historical average annual ungeared property
returns for total property, retail, office and industrial sectors were 10.5 percent, 11.6
percent, 8.9 percent and 13.7 percent respectively. The borrowing cost is estimated to
be 6.0 percent, based on the current ten year Treasury bond rate which is hovering
around 5.5 percent, and a fixed lending margin of 0.50 percent. Notably, gearing
positively magnifies returns. This is particularly the case at very high levels of gearing
(say, 70 percent and above). At moderate levels of gearing (say, 30 percent to 50
percent), it only has a relative modest impact, although significant impact in terms of
absolute total return. Furthermore, the difference in leveraged return profiles across the
core property sectors reflects different return spreads between ungeared returns and
the interest rate.
Next we examine the trade-off between gearing levels and risk. Using equation (2b)
Figure 6 shows gearing-risk profiles by core property sector. Annual risk for ungeared

Gearing and the

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Figure 5.
Geared property returns

Figure 6.
Geared property return
risk

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Figure 7.
Geared property return
and risk

Figure 8.
Geared risk-adjusted
returns

returns for total property, retail, office and industrial are 1.2 percent, 2.0 percent, 1.0
percent, 1.4 percent respectively. The profile for the retail property sector is markedly
different from other sectors showing a significant shift to the right. This reflects the
higher initial ungeared risk which is over one and half times greater than that for the
total property sector. As indicated by equation (2b), each of these profiles is convex in
nature. This suggests that at low gearing levels, incremental units of risk to units of
gearing is proportionately lower than at high gearing levels (say around 80 percent and
above). Interestingly, it suggests that even at moderate gearing levels of 50 percent, the
take-on of additional risk remains relatively low.
Figure 7 shows the trade-off between geared return and geared risk and Figure 8
shows the relationship between geared risk-adjusted returns (RAR) with changing
levels of gearing. As indicated by equations (3a) and (3b), these profiles are linear and
downward sloping, implying that gearing does not improve RAR. As mentioned
earlier, this is because the geared return is decreasing as a proportion of risk with
rising leverage. The industrial sector displays the highest level of RAR whilst the retail
sector exhibits the lowest RAR due to its higher risk on ungeared return.

Variable cost of finance

As previously mentioned, a major factor affecting the gearing analysis is the treatment
of the cost of gearing as it affects both the geared return and geared risk variables. We
now review gearing on property returns by allowing the cost of debt to be variable.
More specifically, the cost of debt is based on the market interest rate, which is
assumed to vary positively with gearing. In illustrating this, consider the following
specification for the relationship between c, i and L:
c f i; L i0 1 aLb

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Equation (4) provides a flexible structure, giving rise to many practical relationships,
depending on values assigned to parameters aand b. For instance, if b 0, then c is a
fixed cost equating to i0 . If a . 0 and b 1, then c represents a positive linear
relationship between the interest rate and leverage. Alternatively, if a , 0 and b , 0,
then c represents a non-linear relationship where the cost of finance increases more
than proportional with higher levels of gearing. Various cost structures for borrowing,
which include a fixed cost at 6.0 percent, a linear cost and non-linear cost structure, are
shown in Figure 9.
The resulting comparative impact of these cost structures on total property returns
and risk is shown in Figures 10 and 11 respectively. Clearly, with rising gearing,
geared returns moderate as one switches from a fixed to a non-linear cost structure. It
is worth noting that the geared return turns negative when gearing reaches 95 percent
with the non-linear cost structure as the value of c is higher than the ungeared return of
10.5 percent. The gearing-risk profile is also affected. The non-linear cost escalation
structure produces a significant rise in risk, causing the profile to shift out towards the
right as shown in Figure 11. This variance progressively rises with increased gearing.
The impact of these cost structures is notable on the risk-reward space, shown in
Figure 12. As expected, as financing costs rise with gearing, the geared return is
diluted and the geared risk is inflated. Accordingly, the rising costs are reflected in
steeper falls in the risk-adjusted return profile as noted in Figure 13.

Figure 9.
Structures for the cost of
borrowing

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Figure 10.
Returns versus gearing

Figure 11.
Risk versus gearing

Dependency between interest rate and ungeared returns

As mentioned in the previous section, there is additional impact on return and risk
when one accounts for the inter-dependency between ungeared property returns and
the cost of debt, via interest rates. In considering this feature of model, the
co-movement between total property returns and interest rates (both the 90 day bill
rate and ten year T bond rate) was examined in an attempt to obtain estimates for the
correlation value. Correlation estimates were found to be between 2 0.60 and 2 0.70,
depending on the sample period and lead/lag structure imposed. Using the average
correlation value, 2 0.65, Figure 14 provides a comparison of gearing-risk profiles with
and without the covariance term. Clearly, the inclusion of the covariance components
(denoted as correlation in the chart) shifts the profile to the right. More importantly, the
shift appears to be far more significant than the change due to different cost structures.

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Figure 12.
Geared return versus risk
for total property

Figure 13.
Risk-adjusted return
versus gearing

Figure 14.
Risk versus gearing

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Figure 15.
Returns vs gearing for
total property (fixed costs)

Figure 16.
Returns vs gearing for
total property (linear costs
with and without
correlation)

Sensitivity analysis impact of interest rate shocks

This section now considers changes to geared returns and geared risk with
exogenous shocks to the interest rate level. Figures 15-18 highlight the impact of
progressive increases in interest rates on geared returns and risk respectively with
fixed and variable financing costs respectively. As expected, as the interest rate
increases, the geared return declines. However, changes in the interest rate level do
not affect the risk variable. As noted in Section III, the risk variable is affected by
interest rate volatility.
In all, a gearing strategy should consider the outlook on interest rates, both in terms
of level and volatility. Consider in a general context that when rates are high relative to
yield, there would be a tendency for gearing levels to be set relatively lower.
Conversely, when interest rates are low relative to yield, there is greater scope for
gearing levels to be set relatively higher.

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Figure 17.
Risk vs gearing for total
property (fixed costs)

Figure 18.
Risk vs gearing for total
property (linear costs with
and without correlation)

V. Optimal gearing level

While one can argue that market conditions are favourable for taking on greater
leverage in property investments, an important question relates to the appropriate or
optimal level of gearing. A starting point for discussing optimal gearing relates to the
trade-off theory of capital structures, which asserts that an optimal level is reached
when the marginal benefit of debt use (such as interest tax shields) equate to its
marginal cost. From an investment perspective this can be interpreted as when the
incremental return due to additional gearing matches the additional risk borne by the
investment (such as financial distress).
From one perspective, optimum gearing levels can be gauged by observing industry
averages. As noted by Stoja and Tucker (2004), the rationale for this is that
macroeconomic conditions tend to have a similar affect on firms in the same industry.
Bowen et al. (1982) report that industry average ratios can be considered to be optimal
if they are stable over time. This aspect is also emphasised by Hull (1999).

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Furthermore, studies by Graham and Harvey (2001), Antoniou et al. (2002) and Bunn
and Young (2004) find evidence of firms targeting industry gearing ratios.
While there appears to be no single or unified response to this question of optimal
gearing, the nature of responses by industry participants tends to focus on the
additional risk take-on by the investment. Rowland (1997) notes that the optimal
gearing is primarily determined by the investors objective and attitude to risk. To a
large extend, the optimal gearing level need to be considered in the context of the
investors investment targets, in terms of risk and return, and alternative investment
strategies.
Furthermore, apart from considering optimal gearing in terms of a single value, it
may well be best approximated by a range. This would be appropriate if gearing levels
are found to vary over time, and move in line with changing market conditions. Indeed
studies by Flannery and Rangan (2004) and Bunn and Young (2004) provide support to
this notion.
The following discusses optimal gearing within the context of various evaluation
criteria, which include targeted return, risk mitigation, and risk-adjusted returns.
These concepts can be applied to either a static investment portfolio or a dynamic
investment portfolio, such as a growth portfolio. In this latter case, evaluation by a
RAR criterion will facilitate selection between a geared and an alternative investment
strategy.

Target return
In this first scenario, we consider an investment fund having a static portfolio with no
acquisitions or divestments. In this case, one way to arrive at an optimal portfolio
would be to match the investment targets of the fund against a leveraged portfolio. For
instance, if the target is an absolute return, then in an attempt to assess geared return
we may review the geared returns shown in Figure 19. By gauging this trade-off the
investment fund can determine what level of gearing is required to achieve their target
returns.

Figure 19.
Returns versus gearing
(total property returns)

Risk mitigation
Alternatively, if the investor has a risk target with respect to gearing, then he can
gauge the trade-off between risk and gearing as shown in Figure 14. For instance, the
chart suggests that the investment can take on additional gearing with relatively less
risk at the 60 percent-70 percent level. Consider if investors are gearing averse, then
their preference would lie in the bottom left hand segment of the gearing-risk profile.
This is referred to as the low risk range where taking on a unit of more gearing
corresponds with a less than unit increase in risk. On the other hand, if investors are
gearing-verse, then their preference would lie towards the upper right segment of the
profile. This is referred to as the high-risk range where taking on a unit of more gearing
corresponds with a more than unit increase in risk. Still, if investors are indifferent
towards gearing, then their preference would fall in the middle the centre point,
which reflects the point where a change in the gearing level equates with a change in
risk. This point and its surrounding points referred to as the moderate risk range,
where the profile exhibits most convexity could be considered as possible gearing
target levels in the absence of information with respect to investors preference for
gearing.
Based on these broad risk ranges, the current gearing levels for LPTs and unlisted
wholesale funds generally fall within the low-risk range. In fact, it appears that gearing
levels for unlisted wholesale funds, averaging between 10 percent-15 percent are too
low as they sit towards the low end of the low risk category.

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Risk-adjusted return
On the other hand, if the investor has a risk-return target, then one could observe this
trade-off as presented in Figures 20 and 21. Here, the investor could set his risk-reward
target and then find the gearing that matches this target. For instance, if the
investment target was a RAR of say, 5.0, then the fund manager could leverage up the
investment to around 75 percent for the total property portfolio. The gearing level of 75
percent would then match with a geared return profile of 24 percent and annual risk of
4.8 percent. However, such a result would vary if rates were to change or different cost
structures were employed.

Figure 20.
RAR for total property
(fixed costs)

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Figure 21.
Geared return versus risk
for total property (fixed
costs)

Lastly, Figure 22 examines the case where an investment fund is in growth phase and
requires one to make a decision about taking on more gearing or to consider alternative
investments. The chart shows the risk-reward trade-off for a leveraged investment as
well as two alternative investments, (1) and (2). With reference to investment (1), given
that it resides above the leveraged investment, then the fund should undertake this
investment rather than undertake leverage in its existing investment portfolio. The
next scenario is more interesting as there is a cross-over point on the risk-reward space
where one investment strategy dominates over the other. Consider, the cross-over point
occurs where the current portfolio is leveraged at 75 percent. Any further gearing
would deliver inferior RAR outcome as opposed to what could be delivered if
undertaking investment (2). Furthermore, undertaking 40% leverage on the existing
core investment represents an optimal point in the sense that the risk-return trade-off
matches that of investment (2).
Apart from determining the optimal gearing level, there is a related issue regarding
the strategy for the adjustment path towards this optimal level as deviations can arise

Figure 22.
Geared return and risk
(total property returns)

due to macroeconomic events and changes in firms/industry fundamentals. The

trade-off theory implies a quick return to the optimal point if there are no adjustment
costs. However, the presence of adjustment costs (and unknown risk factors) may delay
this adjustment. In such circumstances, a multi-period adjustment strategy may well
be pragmatic. Stoja and Tucker (2004) attempt to shed some light on this issue by
estimating a partial adjustment econometric model that captures this multi-period
process.
VI. Concluding remarks
Geared returns depend on two key factors; the gearing level and the difference between
the ungeared return and the cost of debt. Accordingly, with higher gearing levels,
ungeared returns are greatly magnified, both positively and negatively. It is also
shown that risk rises with rising gearing levels with the nature of this relationship
described by the gearing-risk profile. More importantly, it is found that gearing does
not improve risk-adjusted returns.
The cost of debt structure is shown to be significant in understanding the interplay
between the gearing level, return and risk as the relationship between these three
variables differed accordingly. More importantly, it is shown the interdependency
between ungeared returns and the cost of debt (or more specifically, interest rates) also
influences the relationship between risk and gearing by enlarging risk. Consequently,
it should not be dismissed when assessing the impact of gearing on risk.
Using ungeared returns data for Australian real estate assets, it was shown that the
impact of gearing varies across the core sectors. In essence, gearing accentuates the
different risk-return characteristics across the sectors, underpinned by different
drivers of capital return.
Optimal gearing was discussed in the context of formulating an investment
strategy, based on a number of performance criteria, which embedded investor
preferences. With reference to gearing strategy, a possible approach may be one that
monitors the optimal gearing level within a broader business agenda of delivering
enhanced risk-adjusted returns. This requires prudent management of key factors
influencing risks associated with gearing. Such factors include the structure of
borrowed funds, property market cycles and an outlook on interest rates, both levels
and volatility. Such a strategy needs to be tailored across sectors as the study identified
different relationships between gearing and risk.
The study suggests that current gearing levels in LPTs and unlisted wholesale
property funds are relatively conservative. This implies that current gearing could be
increased, in particular for wholesale funds, without taking on substantially more risk
whilst enhancing returns.
Notes
1. For instance, debt financing (both intermediated and non-intermediated) as a share of GDP
(Gross Domestic Product) has increased from about 50 percent in 1980 to just under 100
percent in 1990, and stood at around 150 percent in 2004.
2. Margin lending is a facility offered by financial institutions that gives one a line-of-credit
which allows one to borrow money at call to mainly buy listed shares. Instalments are
packaged financial products that allow one to gain direct exposure to listed shares by
making a part payment upfront and delaying an optional final payment at a later date.

Gearing and the

Australian real
estate market
597

JPIF
25,6

598

3. Note that risk here refers to property risk as opposed to risk in terms of volatility which is
used later in the paper.
4. Note that based on the Modigliani and Miller (1958) model, changes in the capital structure
should have no impact on the overall cost of capital on a pre-tax basis.
References
Antoniou, A., Guney, Y. and Paudyal, K. (2002), Determinants of Corporate Capital Structure:
Evidence from European Countries, working paper series, Centre for Empirical Research in
Finance, University of Durham, Durham.
Bhandari, L.C. (1988), Debt/equity ratio and expected common stock return, Journal of Finance,
Vol. 43, pp. 507-22.
Bowen, R., Daley, L. and Huber, C. (1982), Leverage measures and industrial classification:
review and additional evidence, Financial Management, Winter, pp. 10-20.
Bunn, P. and Young, G. (2004), Corporate capital structure in the United Kingdom: determinants
and adjustment, Working Paper No. 226, Bank of England, London.
CommSec Research (2002), Optimal Mix of Debt and Equity: Property Sector Insight,
Commonwealth Bank of Australia, Sydney.
Flannery, M.J. and Rangan, K.P. (2004), Partial adjustment toward target capital structures,
working paper, University of Florida (also forthcoming in the Journal of Financial
Economics).
Graham, J.R. and Harvey, C. (2001), The theory and practice of corporate finance: evidence from
the field, Journal of Financial Economics, Vol. 60, pp. 187-243.
Hull, R.M. (1999), Leverage ratios, industry norms and stock price reaction: an empirical
investigation of stock for debt transactions, Financial Management, Vol. 28, pp. 32-45.
Modigliani, F. and Miller, M. (1958), The cost of capital, corporation finance and the theory of
investment, American Economic Review, Vol. 48, pp. 261-97.
Rowland, P.J. (1996), Measuring the effects of borrowing on property investments, Journal of
Property Finance, Vol. 7 No. 4, pp. 98-110.
Rowland, P.J. (1997), Property Investments and their Financing, 2nd ed., Lawbook Co., Sydney.
Stoja, E. and Tucker, J. (2004), Target gearing in the UK: a time series unit root and
cointegration methodology approach, Paper No. 05/01, Centre for Finance and
Investment, University of Exeter, Exeter.
UBS Investment Research (UBS) (2004), The Changing Nature of LPTs . . . or Not?, UBS Global
Equity Research, Zurich.
Further reading
Australian Securities Exchange (ASX) (n.d.), Gearing into SMSF a margin lending
alternative, available at: www.asx.com.au
Australian Securities Exchange (ASX) (n.d.), Get positively geared investments through ASX,
available at: www.asx.com.au
Bostwick, J. and Tyrrell, N. (2006), Leverage in real estate investments: an optimisation
approach, paper presented at the 13th European Real Estate Society Conference, Weimar,
7-10 June.
Hoggett, J. and Edwards, L. (1987), Financial Accounting in Australia, John Wiley & Sons,
Brisbane.

Jenkinson, T. (2006), Regulation and the Cost of Capital, Said Business School, Oxford University
and CEPR.
PCA/IPD (2005), Investment Performance Index, December 2005, Property Council of Australia
(PCA) and Investment Property Databank (IPD), Sydney.
Reserve Bank of Australia (RBA) (n.d.), Statistical Tables, available at: www.rba.gov.au
Reserve Bank of Australia (RBA) (2006), Statement on Monetary Policy November 2006: Equity
Markets, available at: www.rba.gov.au, Reserve Bank of Australia (RBA), Sydney.
Reserve Bank of Australia Bulletin (2003), Household debt: what the data show, March, Reserve
Bank of Australia (RBA), Sydney, pp. 1-11.
Reserve Bank of Australia Bulletin (2004), Some comments on securitisation, August, Reserve
Bank of Australia (RBA), Sydney, pp. 62-7.
Reserve Bank of Australia Bulletin (2004), Do Australian households borrow too much?, April,
Reserve Bank of Australia (RBA), Sydney, pp. 7-16.
Corresponding author
Anthony J. De Francesco can be contacted at: adefrancesco@colonialfirststate.com.au

Appendix. Basic model

Consider the following return expression (1) which relates ungeared returns to geared returns:
Rg

Ru 2 cL
1 2 L

A1

1
L
and 2 12L
can be considered weights which sum to one. The
where 0 # L , 1. Note that 12L
expression for the variance for (A1) is given by:

varRg ; s2Rg

2
 2

1
sRu L 2 s2c
1 2 L

A2

We now consider three cases which explore the relationship between return, risk and
leverage.
Case I. Assuming fixed finance costs
Assuming a fixed cost of debt structure which depends on a given interest rate i0 , expression A1
is rewritten as:
Rg

Ru 2 i0 L
1 2 L

A1a

In examining how geared returns changes with gearing, the partial differential of equation (A1a)
is taken whilst holding L constant. This gives:

Rg
Ru
i0
Ru 2 i0
2

L
1 2 L2 1 2 L2 1 2 L2
where:




Ru
Ru

L 1 2 L
1 2 L2

A1a0

Gearing and the

Australian real
estate market
599

JPIF
25,6

600

and




i0 L
i0

L 1 2 L
1 2 L2
Based on (A1b), the curve on the Rg -L space is upward sloping when Ru . i0 and downward
sloping when Ru , i0 .
The variance of (A1a) is given by:


s2Ru
Ru 2 i0 L

A2a
varRg ; s2Rg var
1 2 L
1 2 L2
and the risk expression is given by:

sRg

sRu
1 2 L

A3a

Examining how risk on geared returns changes with gearing, we take the differential of (A3)
with respect to L which gives:

sRg
sRu

.0
L
1 2 L2

A3a0

This states that the risk of geared returns increases with rising L.
The trade-off between geared return and risk can be examined by taking the quotient of
(A1a0 ) and (A3a0 ). This gives:

Rg 
Rg L
Ru 2 i0
:

A4a
sRg L L sRg
sRu
Based on (A4a), the curve on the Rg 2 sRg space is rising whenever Ru . i0 .
The risk-adjusted returns (RAR) is given by:
Rg
Ru 2 i0 L

sRg
sRu

A5

The change in RAR with changing L is given by:

Rg =sRg 2i0

,0
L
sRu

A5a

Expressions A5 states that the RAR curve is linear and A5a states that risk-adjusted returns
linearly decline with rising L.

Case II. Assuming variable finance costs

We now assume that the cost of debt is variable and dependent on an interest rate which varies
with L. As such, c is expressed as c iL.
The return equation is now expressed as:
Rg

Ru 2 iLL
1 2 L

A1b

The partial differential of geared return with respect to L given by:



Rg Ru 2 iL L1 2 Li0 L

L
1 2 L2

A1b0

Gearing and the

Australian real
estate market

where:




Ru
Ru

L 1 2 L
1 2 L2

601



iLL
L
iL

i0 L
L 1 2 L
1 2 L
1 2 L2
and i0 L is the first derivate with respect to L.
The risk equation is given by:


h
i1=2
1
sRg
s2Ru L 2 s2iL
1 2 L
Now consider the differential of risk of geared return with respect to L given by:
i1=2
1 
1   h
i1=2
sRg h 2
2
2 2
:
s

L
s
sRu L 2 s2iL

:
Ru
iL
L
1 2 L2
1 2 L2 L

A3b

A3b0

where:

h
i1=2
h
i21=2 h
i
0:5 s2Ru L 2 s2iL
s2Ru L 2 s2iL
:
s2Ru L 2 s2iL
L

and
i
h 2
sRu L 2 s2iL L 2 s2i0 L 2Ls2iL
L
Denoting s2Ru L 2 s2iL ; f, then (A3 b0 ) can be expressed as:

3
2

p 
21=2
2
2 2
0:5
f
2L
s

L
s
0
iL
i L
sRg
f
5

4
1 2 L
L
1 2 L2
and rearranging gives:

3
2p
21=2
2
2 2
f
f
2L
s

L
s

1
2
L0:5
0
L
iL
i
sRg 4
5

L
1 2 L2
The trade-off between geared return and risk for a given level of leverage is given as:
o1=2

n

Ru 2 iL L1 2 Li0 L s2u L 2 s2iL
Ru 
h
i

sRg L
s2 Ls2 0:51 2 LL 2 s20
u

iL

i L

A4b

JPIF
25,6

Case III. Assuming dependency between interest rate and ungeared returns
In this case an ungeared return is allowed to be dependent on the interest rate. For simplicity, it is
assumed that i is variable over time but not dependent on L. The corresponding return and risk
expressions are given by:
Rg

602

Ru i 2 iL
1 2 L

A1c

sRg

h
i1=2
1
s2Rui L 2 s2i 2 2rsRu si
1 2 L

A3c

Note that the risk expression has an additional component which captures the covariance
between ungeared return and the interest rate. The long-run value of r is expected to be negative
as a positive change in the interest rate will have an adverse affect on ungeared real estate
returns. As such, the risk equation given by (A3c) will be larger than (2).
The partial differential of geared return with respect to L given by:

Rg Ru i 2 i

L
1 2 L2

A1c0

The partial differential of risk of geared return with respect to L given by:
h
i1=2 h
i21=2
2
2 2
2
2 2
s

L
s
2
2
rs
s
s

L
s
2
2
rs
s
Ls2i
Ru
Ru
i
i
Rui
i
Rui
i
Rg

L
1 2 L
1 2 L2

A3c0

h
ih
i21=2
s2Rui Ls2i 2 2rsRu si s2Rui L 2 s2i 2 2rsRu si
1 2 L2

The trade-off between geared return and risk for a given level of leverage is given as:
i1=2

h 2

2 2
R
2
i
s

L
s
2
2
rs
s
Ru
ui

i

Rui
i
Rui 
h
i

sRg L
2
2
s
Ls 2 2rs s
Rui

Ru i

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A4c