Many thanks for those of you that could attend the latest RES Roundtable on modelling CVAs.

Stephen Ashworth of Synrex provided an overview of the empirical data utilised in credit risk analysis in the fixed income and equity markets and explained how to estimate the level of default risk implied by current pricing.

The key risk triggers to individual corporate defaults were identified as:

• cyclical (economic climate);
• structural (e.g. technological change or increased competition), and;
• specific (e.g. unwise expansion or acquisitions).

Cyclical and structural drivers affect multiple companies and therefore create correlations in credit risk amongst groups of companies.  So in a downswing we might assume that all tenant default risks are higher, but to model the risk of a cluster of defaults we should model an elevated risk of default for all tenants in a particular industry.

Modelling CVAs in a property cash flow

The implications of CVAs for real estate cash flow modelling focussed on the outcome for marginal stores: what should the rent be reduced to, for how long, and at what level should it then return to?

The evidence from the ‘coal face’ in the room was that the rent agreed can be lower than the ERV, sometimes nil.  Modelling the impact of CVAs is therefore more complicated than modelling a ‘normal’ insolvency as the outcome depends on the ERV, the trading of the occupier in that unit and then the assumed discount to ERV.

An industry response

The discussion then turned to the wider implications of CVAs for the leasing of retail space: if the lease no longer affords the same protection to the landlord in a cyclical downswing, or where individual stores trade badly, then why continue to take a passive leasing approach?

Factory outlet parks for example have very short leases with poorly performing retailers quickly removed. Would this not be a better model for all retail stores?

Two ‘truisms’ of CVAs were widely agreed:

1. The impact is greatest on a longer lease, as on a shorter lease the occupier has the option to leave the unit soon anyway – one question not discussed was whether financially weak tenants were more likely to exercise breaks and not renew their lease?
2. The impact of CVAs is potentially positive for value in a strong market where NERV might be higher than the current rent

The group then quickly braved the impact on expected and required returns and agreed that:

1. CVAs (insolvencies generally) lower the expected return from real estate due to lower income, longer vacancy periods and higher costs in a downswing
2. CVAs also increase the required return from real estate due to the elevated downside risk to the income

The view was also that it is very difficult to model the impact of default risk on the expected return so adding a premium to the required return is the only practical option open to investors.