Department of Real Estate and Construction Management Thesis no. 175
Real Estate Development and Financial Services Master of Science, 30 credits Financial Services
Corporate Bonds
– An Emerging Source of Financing for Swedish Real Estate
Companies
Abstract
Banks have become increasingly restrictive in their lending towards commercial real estate, a development that is expected to increase due to new regulations. This has caused Swedish companies, amongst them several real estate companies, to obtain financing through the capital markets. The main focus of this paper is corporate bonds, and those Swedish real estate companies that have issued bonds. We distinguish between government owned and other real estate companies, as their creditworthiness differ considerably. The research is based upon interviews with people in the industry as well as pre-existing secondary data.
The Swedish bond market is underdeveloped as Swedish companies traditionally obtain debt through bank loans. Until a few years ago, only government owned real estate companies had issued bonds; although since 2010, several real estate companies without government ownership have issued unsecured bonds, this as availability of bank loans has decreased due to new regulations. Increased bank funding costs and increased bank loan margins has further caused prices of bank loans to rise. Swedish banks are increasingly reluctant to finance higher LTV-levels, and loans are conditioned with an increasing number of covenants. Issues of corporate bonds provides the benefit of funding diversification – decreasing overall financial risk; and allows for higher LTV’s as financing on top of bank loans. In order for corporate bonds to be an alternative to bank loans, secured bonds would have to be issued. However, there is some uncertainty regarding how such bonds would be priced. We have investigated the yield-determinants of bonds issued by real estate companies, as well as the motives for real estate companies to issue bonds. Investors perceive corporate bonds as an increasingly attractive investment compared to other asset classes, fuelling a development towards
Title Corporate Bonds – An Emerging Source of
Financing for Swedish Real Estate Companies
Authors Herman Donner and Victor Svensk
Department Real Estate and Construction Management
Master Thesis number 175
Supervisor Han-Suck Song
Keywords Real Estate, Corporate Bonds, Capital
Structure
Acknowledgement
First and foremost, we would like to thank our supervisor Han-Suck Song, for his excellent guidance throughout the entire process of writing this thesis
Secondly, we would like to thank Rutger Arnhult, Anton Drott, Oskar Ekenger, Magnus Grape, Erik Gärdén, Johan Hansen, Lars Hegg, Sven-Olof Johansson, Magnus Kihlgren, Björn Lindström, Johan Malmberg, David Mindus, Jens Rastad, Joacim Sjöberg, Pontus Sundin and Erik Visteus, all of which took time to meet with us and answer our research questions.
We would also like to thank Simon Kjellström for the telephone interview we conducted, as well as Niclas Forsman and Michael Moschewitz for the thorough answers of our questions they provided us with through e-mail.
A further thanks goes to Ebba Swahn for an early interview when we worked with our Thesis Proposal, as well as Mikael Söderlundh that provided us with valuable thoughts on the subject.
We would like all of those that have helped us to know that we deeply appreciate their effort, and without them this thesis would not have been possible.
Hopefully this paper will provide a reader with a clearer picture of the current state of the Swedish corporate bond market, and its increasing influence on the real estate sector.
Stockholm, May 24th, 2012
Herman Donner and Victor Svensk
Sammanfattning
Banker har blivit alltmer restriktiva i sin utlåning till kommersiella fastigheter, en utveckling som förväntas öka på grund av nya regleringar. Detta har fått svenska företag, bland dem flera fastighetsbolag, att söka finansiering via kapitalmarknaden. Tyngdpunkten i denna uppsats är företagsobligationer, och de svenska fastighetsbolagen som har emitterat obligationer. Vi skiljer mellan statligt ägda och andra fastighetsbolag då deras kreditvärdighet skiljer sig avsevärt. Forskningen bygger på intervjuer med personer i branschen samt befintlig information.
Den svenska obligationsmarknaden är underutvecklad i många avseenden, då svenska företag traditionellt sett använt banklån. Fram tills för några år sedan hade endast statligt ägda fastighetsbolag emitterat obligationer, men sedan 2010 har flera fastighetsbolag utan statligt ägande emitterat icke-säkerställda obligationer då tillgängligheten av banklån har minskat på grund av nya bankregleringar. Detta i kombination med bankers ökade finansieringskostnader samt höjda lånemarginaler har lett till högre priser på banklån. Svenska banker är ovilliga att finansiera högre belåningsgrader, och lån är allt oftare betingade med ett ökat antal villkor.
Emitterande av företagsobligationer ger emittenten fördelar då finansieringen diversifieras – vilket minskar den totala finansiella risken, samt ger möjlighet till högre belåning som finansiering på toppen av banklån. För att företagsobligationer skall bli ett jämförbart alternativ till banklån skulle säkerställda obligationer behöva emitteras, men det råder viss osäkerhet kring hur sådana obligationer skulle prissättas. Vi har undersökt räntesättningsprocessen för obligationer emitterade av fastighetsbolag, samt de motiv som fick de företag som emitterat obligationer att göra detta. Investerare uppfattar företagsobligationer som en allt mer attraktiv investering jämfört med andra tillgångsslag,
Titel Företagsobligationer – En tilltagande
finansieringskälla för svenska fastighetsbolag
Författare Herman Donner och Victor Svensk
Institution Institutionen för Fastigheter och Byggande
Examensarbete nummer 175
Handledare Han-Suck Song
Nyckelord Fastigheter, Företagsobligationer,
Kapitalstruktur
Förord
Vi vill först och främst tacka vår handledare Han-Suck Song. För hans utmärkta vägledning genom hela skrivprocessen av denna avhandling.
Vi vill också tacka Rutger Arnhult, Anton Drott, Oskar Ekenger, Magnus Grape, Erik Gärdén, Johan Hansen, Lars Hegg, Sven-Olof Johansson, Magnus Kihlgren, Björn Lindström, Johan Malmberg, David Mindus, Jens Rastad, Joacim Sjöberg, Pontus Sundin och Erik Visteus, för att de tog sig tid för att träffa oss och besvara våra frågeställningar.
Vi vill också tacka Simon Kjellström för den telefonintervju vi haft, samt Niclas Forsman och Michael Moschewitz för de utförliga svar de gett oss via e-post.
Ytterligare tack går till Ebba Swahn för vår tidiga intervju under skrivandet av vårt uppsats- förslag, samt Mikael Söderlundh som försett oss med värdefulla tankar om ämnet.
Vi vill att alla de som hjälpt oss skall veta att vi uppskattar deras hjälp, och att utan dem skulle den här avhandlingen inte ha varit möjlig att skriva.
Förhoppningsvis kommer detta dokument att ge en läsare en tydligare bild av den svenska marknaden för företagsobligationer och dess tilltagande inflytande på den svenska fastighetssektorn.
Stockholm 24 maj 2012
Herman Donner och Victor Svensk
1. INTRODUCTION 8
1.1 INTRODUCTION 8
1.2 OBJECTIVE AND PURPOSE 10
1.3 RESEARCH QUESTIONS 11
1.4 LIMITATION 12
1.5 BACKGROUND 12
2. METHOD 15
2.1 CHOICE OF METHOD 15
2.1.1 RESEARCH DESIGN 15
2.2 DATA COLLECTION 16
2.2.1 COMPARATIVE CASE STUDIES 16
2.2.2 INTERVIEWS 17
2.2.3 CHOICE OF INTERVIEW RESPONDENTS 17
2.2.4 SECONDARY DATA 18
2.3 THE CREDIBILITY OF THE STUDY 18
2.3.1 RELIABILITY 18
2.3.2 VALIDITY 19
2.3.3 REPLICABILITY 19
2.4 DIVISION OF WORKLOAD 19
3. FINANCIAL THEORIES, INSTITUTIONS AND INSTRUMENTS 20
3.1 CAPITAL STRUCTURE 20
3.1.1 PREFERRED STOCK 21
3.1.2 MEZZANINE DEBT 21
3.1.3 CAPITAL STRUCTURE THEORY 21
3.2 RISK AND RISK MANAGEMENT 25
3.2.1 RE-‐FINANCING RISK 26
3.2.2 INTEREST RATE RISK 26
3.2.3 CREDIT RISK 26
3.2.4 LIQUIDITY RISK 26
3.2.5 MARKET RISK 26
3.2.6 HEDGING 27
3.2.7 BOND RATINGS 28
3.2.8 REAL ESTATE RISK MANAGEMENT THEORY 28
3.2.9 CREDIT RISK ASSESSMENT THEORY 29
3.3 FINANCIAL REGULATIONS 30
3.3.1 BASEL III 30
3.3.2 SOLVENCY II 32
3.4 THE FINANCIAL MARKETS 33
3.4.1 CORPORATE BONDS 34
3.4.2 CORPORATE BOND PRICING THEORY 37
3.4.3 THE CORPORATE BOND MARKET 38
3.5 REAL ESTATE IN THE SWEDISH BOND MARKET 46
3.5.1 ISSUERS 47
3.5.2 GOVERNMENT-‐RELATED ENTITIES 47
3.5.3 NON-‐GOVERNMENT-‐RELATED ISSUERS 50
3.5.4 OTHER RECENT ISSUERS 55
4. EMPIRICAL STUDY 56
4.1 INTERVIEW RESULTS 56
4.1.1 MARKET OVERVIEW 56
4.1.2 CAUSES OF CURRENT INCREASED BOND MARKET ACTIVITY 56
4.1.3 ISSUE CONDITIONS 59
4.1.4 RATINGS 60
4.1.5 BOND STRUCTURES 60
4.1.6 INVESTORS 62
4.1.7 ISSUE PROCESS 65
4.1.8 YIELD DETERMINATION 66
4.1.9 MARKET LIQUIDITY AND SECONDARY TRADING CONDITIONS 67
4.1.10 ISSUER MOTIVES 68
4.1.11 CORPORATE BOND DISADVANTAGES 73
4.1.12 OTHER DEBT INSTRUMENTS 75
4.1.13 POSSIBLE FUTURE DEVELOPMENTS 76
5. ANALYSIS 79
5.1 CAUSES OF CORPORATE BOND MARKET GROWTH 79
5.2 CAPITAL STRUCTURE THEORY 80
5.3 CORPORATE BOND RISK PREMIUMS AND RISK IMPLICATIONS 81 5.4 POSSIBLE CONSEQUENCES OF CORPORATE BOND MARKET GROWTH 82
5.5 FUTURE SECTOR DEVELOPMENTS 82
5.6 THE BORROWER AND LENDER RELATIONSHIP 84
6. CONCLUSION AND SUMMARY OF FINDINGS 85
7. BIBLIOGRAPHY 88
7.1 WRITTEN SOURCES 88
7.2 WEB BASED SOURCES 96
7.3 VERBAL SOURCES 99
7.3.1 INTERVIEWS 99
7.3.2 OTHER VERBAL SOURCES 100
8. APPENDIX 101
8.1 REAL ESTATE COMPANY INTERVIEW QUESTIONS 101
8.1.1 REAL ESTATE COMPANY INTERVIEW QUESTIONS – SWEDISH 101 8.1.2 REAL ESTATE COMPANY INTERVIEW QUESTIONS – ENGLISH 102
8.2 BANK AND CONSULTANCY INTERVIEW QUESTIONS 103
8.2.1 BANK AND CONSULTANCY INTERVIEW QUESTIONS – SWEDISH 103 8.2.2 BANK AND CONSULTANCY INTERVIEW QUESTIONS – ENGLISH 105
1. Introduction
1.1 Introduction
Traditionally Swedish real estate companies obtain financing through bank loans (Donner and Svensk, 2010). As Sweden is a bank-oriented financial system – in which the banking system provides funds for investments – in contrast to market-oriented economies like the U.S. – with investment to a large extent being financed through the financial markets by various types of actors, such as private investors and corporations with excess capital – comparably few companies fund themselves through the capital market (Levine, 2002; Berggren and Silver, 2011).
The current Swedish market for commercial real estate is already characterized by new and considerably more stringent bank lending policies, inhibiting smaller and less equity strong real estate investors. We have already found that professionals in the real estate sector experience that banks prioritize larger and older customers, in line with their increased risk- averseness (Swahn, 2011). The new regulations that are being enforced in the aftermath of the recent financial crisis will increase banks’ cost of capital, as their required debt-coverage ratios are increased, liquidity buffers are to be amplified – increasing costs as these funds provide a lower return than other assets – and funding maturities will have to be extended (Sveriges Riksbank, 2010). These new regulations will inevitably increase the price of bank loans as well as reduce the availability of financing through banks (Gunnarsdottir and Lindh, 2011). These forthcoming regulations are already influencing the price of bank loans upwards as well as decreasing loan availability (Pantzar and Gullmert, 2011).
Sweden has a comparably small and undeveloped capital market in a global comparison; low liquidity, transparency, and limited as well as flawed statistics are hindering factors mentioned by market participants (Gunnarsdottir and Lindh, 2011). 80% of Swedish corporate debt is in the form of bank loans, as Sweden lacks tradition of other debt financing than through banks. The Swedish capital market is primarily utilized as a funding source by a few very large corporations – besides issues of government debt – such as Atlas Copco, Telia
could without great effort obtain financing in foreign markets as well (Gunnarsdottir and Lindh, 2011).
Rating agency Fitch state in a July 2010 report that availability of bank loans is a key determinant of bond market growth, finding that if bank lending continues to be at the current low levels firms will turn to the bond markets when re-financing corporate debt (Fitch, 2010).
The global real estate consultancy firm CB Richard Ellis conclude in their “Real Estate Investor Intentions 2012” report that the low availability of financing is the principal cause of concern, threatening a recovery of the commercial real estate sector in Europe (Damesick, 2012). Because real estate companies carry large amounts of debt in relation to other sectors, availability and pricing of debt is a key issue for real estate companies. Real estate cash flows are found to be comparable stable in regard to financial cycles (Giambona et al., 2008), and hence allow for the typically large amounts of debt real estate companies carry (Kjellström et al., 2012). Since bank financing has proven to be sensitive during periods of systemic stress – as during the financial crisis (Chui et al., 2010) – and is currently increasingly difficult to obtain when banks are lowering LTV-requirements and increasing their loan margins, a demand for alternative sources of financing has emerged amongst real estate companies (Josefsson et al., 2012) and during recent years a growing number of real estate companies have issued corporate bonds. Issues of preferred stock is another alternative financing source utilized by some Swedish real estate companies (Kjellström et al., 2012).
Investors’ interest regarding investment in corporate bonds is also increasing on the Swedish market – providing a growing bond market investor base to meet an increased number of bond issues (Pantzar and Gullmert 2011; Josefsson et al. 2012). As stock market returns have proven to be increasingly volatile during the preceding decade, and Swedish government bonds offering historically low returns; corporate bonds are emerging as an increasingly attractive investment alternative as few other alternatives offer stable and comparably high returns (Grundberg-Wolodarski, 2012; Josefsson et al., 2012).
A development towards increased financing through the capital markets will have implications – possible consequences this paper will aim to explore – when lenders and borrowers that previously haven’t interacted will do business through instruments that are comparably new to the Swedish real estate sector. Pareto Öhman, a Swedish investment bank,
examining Swedish real estate companies with unsecured bonds outstanding; as well as analysing the credit characteristics of the real estate sector (Kjellström et al., 2012). The report stresses that investors should understand the implications of real estate sector characteristics in relation to credit risk, since operational stability and leverage differ from other sectors. The authors also find the Swedish high yield bond market to be undeveloped, which has led to a mispricing of bonds (Kjellström et al., 2012).
Because investors’ ability to finance purchases of real estate is a prerequisite for a liquid real estate market, as well as a significant determinant of real estate values, the subject of future development of debt availability is of great interest. In light of new regulatory constraints on bank lending, the corporate bond market has emerged as an increasingly interesting alternative. Globally, corporate bonds have a much larger share of total financing than in Sweden, with the U.S. as an example of a nation in which larger corporations lend through the capital markets as a common and viable alternative to bank loans (Berggren and Silver, 2011).
If financing through the capital markets does increase further, it would imply a partial shift in the Swedish financial sector, which is regarded as a prime example of a bank-oriented economy.
1.2 Objective and Purpose
Due to low current accessibility of financing through banks (Swahn, 2011), our underlying hypothesis is that there is a tendency towards a development of which financing through corporate bonds among real estate companies will increase, although to an uncertain extent – because of a search for alternatives when bank financing isn’t available. This belief causes us to examine this market, and the implications that this prospective development will have for the involved parties.
Our aim is to examine the possibilities for real estate companies to obtain alternative sources (in contrast to bank loans) of financing, with a primary focus on corporate bonds. The issue of pricing of risk is a key problem, causing us to examine the process of determining bond yields. There exists an abundance of historical examples of mispricing of assets due to overlooked and unknown risk factors, such as investors and rating agencies not understanding
relation to handling of the central risks of real estate investment caused by debt structure – interest rate risk and re-financing risk – and how real estate companies manage these risks when issuing bonds.
Our paper will cover the overall bond market for Swedish real estate companies, as well as exploring the different types of possible bond structures. We aim to study the underlying reasons for choosing financing through corporate bonds, and the implications and viewpoints by the parties involved, i.e. issuers and investors.
1.3 Research Questions
The aim of our research questions is that the answers will give us a complete picture of our subject; subsequently testing our hypothesis of an increasing importance of bond financing amongst real estate companies.
1. How does the current overall situation for bond market financing look like? How obtainable is the financing? What are the major advantages and motives for real estate companies to issue bonds? Which are the disadvantages compared to bank loans?
2. What are investor preferences, demands and views on various risks? Are there any distinctive characteristics regarding real estate companies having issuing corporate bonds?
3. What are the current trends that will influence future development of bond market financing? What developments are expected to occur during the coming years (1-5)? What are the implications for real estate companies, banks and financial intermediaries?
4. What implications concerning overall risk level does financing through the capital markets have on these real estate companies? How does the yield-determining process for real estate corporate bonds look like?
1.4 Limitation
The subject of this paper is relevant in regard to several sources of debt being alternatives to bank loans, although our main focus will be debt issued on the credit market – corporate bonds, and to some degree certificates as a source of short-term debt. Other alternative sources of financing such as preferred stock and mezzanine debt will not be highlighted in this paper. The topic is general for all corporations in need of financing, although this paper will concentrate on bonds issued by real estate companies. The paper will examine the current and expected development of capital market financing for real estate companies in contrast to bank loans. Our research is limited to Sweden, and Swedish real estate companies and the Swedish capital market.
1.5 Background
Preceding the global financial crisis of 2007 investors had rationalized rapidly increasing property prices, increasing equity values and increasing U.S. current account deficits with the notion of a new economy – that financial innovation and an expected perpetually increasing U.S. productivity were examples of new elements of the global economy. Investors referred to the “Great Moderation” in macroeconomic volatility that justified increasing equity values (Reinhart and Rogoff, 2008).
The origin of the 2007 crisis was the rapid expansion of U.S. subprime loans issues, which doubled during the period between 1996 and 2006 (Ingves, 2008). As interest rates rose during 2005, so did the default rates of the subprime loans (Ingves, 2008) – a development further amplified by loan structures that often entailed initial periods of low interest-only payments (Veneziani, 2011). The complex bundling of these mortgages proved to be fundamentally flawed during a period of falling house prices, as the instruments became extremely non-transparent and illiquid (Reinhart and Rogoff, 2008). Aggressively leveraged banks in the U.S. and in Europe had to be rescued by government interventions. In the aftermath of the U.S. investment bank Lehman Brothers’ demise investors fled to perceived safe havens, as no investments were perceived as non-toxic – causing global financial liquidity to dry up, and consequently great difficulty for organizations dependant upon the
It was not the primary losses incurred due to falling values of non-prime mortgage backed securities that were the cause of the turmoil; it was the systemic linkage (Hellwig, 2009). This inter-linkage instigated the largest geographical spread in the history of financial crises (Ingves, 2008). The U.S. benchmark interest rate is still at a historically low level of 0,25%, and the U.S. Federal Reserves has stated that its interest rate will remain low at least through late 2014 in order to support a U.S. economic recovery (U.S. Federal Reserve, 2012). The Eurozone benchmark interest rate is currently at 1% (Inman, 2012).
Shortly following the crash of Lehman Brothers global attention switched towards the surfacing European debt crisis – as Greece’s true deficit was revealed, numbers previously covered up by government officials (New York Times, 2012). Investors now cast doubts on the ability of several European countries’ ability to honour their obligations – reviewing previous beliefs regarding which debts that are risk-free – Greece, Portugal and Ireland have already received European Union bailout funds; while Spain, France and Italy are heavily questioned by increasingly doubtful investors (Inman, 2012). The crisis stems from the fact that when most countries in the European Union implemented the Euro as their common currency, less credit worthy countries – such as Greece – could borrow money at the same interest rate as stronger borrowers – like Germany (Xaquín et al., 2011). This caused a surge for credit that ballooned the deficit in Greece, while also fuelling real estate booms in Ireland and Spain –subsequently creating bubbles (New York Times, 2012).
The global financial crisis and the following euro crisis have led to a storm of proposals and investigations about new regulations to prevent future bank failures, such as those recently experienced. The most prominent is the upgrade of the Basel II regulations, Basel III; since the financial crisis clearly illustrated that Basel II did not account for – and fully capture – the inherent risks in the banking system. The regulations will be gradually imposed as of 2013 and will increase both liquidity requirements and the quality of banks’ capital; therefore making banks more resilient to financial turmoil (Sveriges Riksbank, 2011(b)). Another noticeable proposal is the Solvency II regulations that effects all European insurance companies and is designed to strengthen the relationship between solvency demands and risk;
while also providing a better consumer protection and integrating the European financial markets (Svenska Finansinspektionen, 2012).
Declining investor confidence has led to increasing borrowing costs for banks and financial institutions, increasing bank-funding costs. New regulations have already influenced the price of bank debt upwards (Petersen, 2012). Because bank loans were scarce during the height of the financial crisis (Chui et al., 2010) an increasing number of companies turned attention to issues of corporate bonds (Fitch, 2010), making the global corporate bonds issues by nonfinancial institutions almost double, accumulating 1,5 trillion USD, in 2009 – and an historic high of 548 billion USD in Western Europe (Roxburgh et al., 2011).
The Swedish bond market is currently small and comparably undeveloped (Sveriges Riksbank, 2011(a); Gunnarsdottir and Lindh, 2011) and its participants lack knowledge that is essential in a well-functioning bond market. Increased bond market volumes – with bonds being a viable alternative to bank financing – would be a desired development according to Gunnarsdottir and Lindh (2011), as a better functioning Swedish bond market would lead to:
more efficient financial intermediation, improve the pricing of credit risk at different maturities, and create a possibility for Swedish companies to diversify their financing (Gunnarsdottir and Lindh, 2011).
2. Method
2.1 Choice of Method
Our research will primarily be conducted by collection of data – such as prospects by companies issuing bonds – and interviews of experienced professionals. We believe that our research objectives and the formulation of research questions imply that our research questions are structured in nature. We will conduct case studies on commercial real estate companies that have issued corporate bonds, which will provide us with insight in the development of financing structure over recent years – with the expected shift from bank loans toward capital markets (issuing of bonds) in focus – and the underlying arguments of the development over time. Besides interviewing and gathering information on the companies that are subjects to our case studies, we will gain additional information by interviewing other relevant sources, such as the financial institutions that facilitate the issuing of bonds, and real estate consultancy firms.
2.1.1 Research Design
Our study will result in a research paper that describes and analyses current and possible future market developments of the Swedish corporate bond market and real estate companies’
financing choices. We will investigate the prerequisites for real estate companies to borrow through the capital markets and what implications this has on real estate companies’ risk characteristics (high leverage of illiquid assets, interest rate risk, re-financing risk, etc.).
Guidance of recent developments, such as the euro-crisis and new regulations; theories related to the subject; as well as our qualitative research and comparative case studies – which allows data collection from primary sources – will be used as data.
2.2 Data Collection
The primary collection of data is made through qualitative interviews with market professionals. As a large part of our study will be interviews, the depth and reasoning character of the questions will make the answers obtained by the interview-subjects an interpretation of information, and consequently a form of analysis themselves. The answers will be compiled and thereafter analysed in a larger context. A possible drawback of our choice of qualitative interviews is that a large part of our findings are based on the interview – which can differ considerably, causing difficulties to state the results as general. The secondary data, on the other hand, is based on publicly available data from various well- renowned sources.
2.2.1 Comparative Case Studies
Our choice of doing case studies is suitable due to the subject’s complexity, and its difficulty to understand outside its natural setting. We believe that when researching a subject such as ours – with limited previous research available and of which current development is examined – a qualitative method is most suitable. A large statistical study with standardized questions wouldn’t give us the in-depth knowledge of the subject that detailed questions during a personal interview does. Our comparative case studies will consist of Swedish commercial real estate companies that have issued debt in the form of corporate bonds on the Swedish bond market. Companies Corem Property Group, FastPartner, Klövern, Kungsleden, Sagax and Vasakronan are the base of our case study, of which Vasakronan differs due to the company’s size and ownership by the AP-pension funds. This study primarily aims at exploring current corporate bond market conditions, primarily in regard to privately owned real estate companies without government-ties. Vasakronan is however included in the research, due to the substantial experience of the subject the company posses – being a very large and established issuer. We will ask the respondents from each company the same questions, compare them with each other, with related theories and other company facts from annual-reports etc., and consequently try to draw conclusions based on the answers.
2.2.2 Interviews
Interviews are frequently viewed as the best data collection method (Ghauri and Grønhaug, 2010). There are two types of research-oriented interviews: structured interviews and unstructured interviews (Ghauri and Grønhaug, 2010). The initial is what is also known as a survey research; with standardized questions that emphasis fixed responses, which can be used as a sample in statistical methods (Ghauri and Grønhaug, 2010). The latter gives the respondents the freedom to discuss their opinions, relations and behaviour and the interviewer just gives lead questions – which are not structure before hand – focusing on “why” and
“how” (Ghauri and Grønhaug, 2010). There is, however, a form of interview that stands somewhere in the middle of the aforementioned two forms, which is referred to as “semi- structured” (Ghauri and Grønhaug, 2010). Our interviews falls into this last category, as we will have structured, predetermined questions, that are wide enough to involve some of the respondents’ personal opinions, but structured enough to enable us to control the interview and obtain the facts we need.
2.2.3 Choice of Interview Respondents
When examining the conditions of bond market financing for Swedish real estate companies we have conducted interviews with real estate and banking professionals representing real estate companies having issued bonds and real estate consultants that experience market developments in their daily work or that actively analyse market developments, as well as representatives of the banks that facilitate bond issues and provide bank loans.
Interviewed real estate representatives are: Rutger Arnhult, CEO, Klövern and up until December 31st 2011, CEO, Corem Property Group; Lars Hegg, CFO, Kungsleden; Sven-Olof Johansson, CEO, FastPartner; Björn Lindström, CFO, Vasakronan; and David Mindus, CEO, Sagax.
Interviewed real estate consultants are: Anton Drott, Real Estate Corporate Finance, PWC;
Magnus Grape, Capital Market Analyst, Johan Malmberg Partner and Project Manager, Capital Market Project, and Jens Rastad, Partner and Project Manager, Capital Market Project, Tenzing; Erik Gärdén, Senior Partner and Head of Corporate Finance and Property Finance, Leimdörfer; Niclas Forsman, Analyst, and Michael Moschewitz, Partner and Head of Debt Advisory, Catella; and Erik Visteus, Associate Director Capital Markets, Jones Lang
Interviewed representatives of banks are: Oskar Ekenger, Associate, DCM Loan Origination Sweden and Poland, and Pontus Sundin, Director, Debt Capital Markets, Nordea Markets;
Johan Hansen, DCM Origination, Danske Bank; Magnus Kihlgren, Fixed Income, Corporate Bond Sales, Carnegie Investment Bank; Simon Kjellström, Credit Research Analyst, Pareto Öhman; and Joacim Sjöberg, Vice President Corporate Finance, Swedbank.
We have further conducted an earlier interview with Ebba Swahn, Project Manager, Property Transactions, Svenska Bostadsfonden, which covered some areas of concern in this study although not sharing the same structure of questions as the other interviews. Also, Mikael Söderlundh, Head of Research and Partner, Pangea Property Partners, has provided us with input on the subject.
2.2.4 Secondary Data
The secondary data is based on established theories related to the subject of the study and data such as annual reports, prospects and press releases from the companies that are studied in our case studies, which can be found on the companies’ official websites. A search for written sources will be made, to the largest extent possible, through highly recognized and well renowned databases, such as Google Scholar, Oxford Scholar, The Swedish Central Bank, and other science journals and research papers; as well as different research institutions and corporations. When highly updated information is required, like for example information concerning recent market developments or the current euro-crisis, prominent newspapers such as The New York Times and Wall Street Journal will be used if necessary.
2.3 The Credibility of the Study
In order to be able to state a research as credible and trustworthy it needs to be based on dependable data and it needs to have a high reliability, validity and replicability.
2.3.1 Reliability
Reliability describes how reliable the conducted study is, i.e. how easily the same results can be achieved if repeated. Because of the difficulty to re-create the interviews that is the base of our empiric study, both in the sense of the solid facts as well as the personal opinions, the
2.3.2 Validity
Validity refers to how sound the conducted study’s measurement is, that is: the absence of systematic measurement errors (Nationalencyklopedin, 2012(a)). Our choice of method requires us to have an ability to study our subjects many dimensions, and thereafter draw an integrative interpretation of our findings. The validity of our findings is solely dependent on the logic that we have employed in our study and the quality of our measurements. Worth mentioning is that the interviews may be angled in favour of the interview objects options, occupation or to favour their own company, which may lead to flawed results – lowering the study’s validity. We will try to minimize this impact by critically scrutinizing the answers, by formulating the questions as well as possible and also recording the interview sessions, if allowed.
2.3.3 Replicability
Replicability refers to the notion that someone, with similar skills and knowledge, can conduct the same study as the authors and yield the same result. This might, as aforementioned, be difficult to do, as the interview sessions are hard to identically re-create;
which indeed lowers the replicability of the study, but this is as mentioned counterweighted by the fact that all written sources are generally available to the public.
2.4 Division of Workload
According to new standards every paper written by more that one author should have a section covering which co-author has done what. We have found it difficult to achieve this because of the fact that even if one person has written one passage, or one section, the other one always checks it, changes it and adds to it what he sees fit – or what is lacking.
Subsequently, we can only say that both authors have contributed to the complete research and to all sections equally.
3. Financial Theories, Institutions and Instruments
3.1 Capital Structure
The structure of financing sources of which a company finances its operations and growth – its capital structure – refers to the company’s usage of external long- and short-term debt; as well as its usage of internal debt, common equity and preferred equity. Besides the choice of overall usage of leverage – the proportion of debt and equity – corporations have to decide upon which kind of debt to utilize, depending on preferences and the specific situation (Berk and DeMarzo, 2011). When analysing the capital structure of a company, leverage is an indication of the company’s overall level of risk exposure. However, this does not depict the whole picture of a company’s risk-taking, since different types of debt carry widely diverging risk characteristics. Debt maturities, the overall company cash flow and its risk exposure are factors affecting the overall level of risk for an organization.
The wide variety of sources of financing available to corporations creates a great need for consideration of the alternatives, as the characteristics differ considerably. Preferred equity does have some debt characteristics – such as having a higher priority than common equity in case of default and paying a fixed return – therefore having both equity and debt characteristics. In regard to priority to cash flows, different financing sources provide characteristics suitable to differing lender and borrower preferences. Mezzanine debt – having seniority to cash-flows over equity, but being less prioritized than other debt – provides lenders with a higher return (and risk) relative to purchases of bonds, yet offering lower risk than equity, as well as providing the borrower with the option of higher leverage, although to a higher price.
Financing sources directly effect the risk level of a firm by the implications and conditions that they carry. Covenants of bank loans, regulating the conditions under which the bank is legally allowed to cancel the loan, directly influences the firm by regulating the allowed level of risk-taking, while also posing as a considerable risk due to the consequences associated with breaching the loan agreement. Firms therefore have a wide variety of considerations
3.1.1 Preferred Stock
Preferred stock have a higher claim on a company’s assets than common stock, and can be described as a hybrid that is somewhere in-between common stock and bonds, as it has characteristics from both (Fuller and Thompson, 1993). It provides equity characteristics in the sense that an investor buys a share of the company (although usually without the voting rights) and takes part in the appreciation (while this might sometimes be limited); however, preferred stocks also offers debt – bond – characteristics because it pays a fixed dividend (coupon), which takes president over common stock dividend (Fuller and Thompson, 1993).
3.1.2 Mezzanine Debt
Mezzanine debt refers to a loan that is in-between equity and senior debt. These loans commonly have particularly flexible terms – such as embedded options like rights, warrants and stock call options – as they rank lower than senior debt in event of default, and are consequently more risky, which in turn gives them a higher interest rate; and they are generally purchased when investors want to lend to growing firms, rather than to add equity, as well as commonly associated with buyouts and acquisitions (Musatov and Robinson, 2011).
3.1.3 Capital Structure Theory
Modigliani and Miller – whom both have received the Nobel Memorial Prize in Economic Sciences (Modigliani in 1985 and Miller in 1990) – in 1958 argued that a firm’s value is independent of its financing decisions, regarding the choice between basic debt and equity, as well as dividend policy, arguing that firm value is determined solely by earnings potential and risk of its underlying assets (Modigliani and Miller, 1958). The foundation for this proposition of ”irrelevance” is the assumption of perfect and frictionless asset markets – without transaction costs, taxes and a bankruptcy option; with perfect informational symmetry; and investors being able to borrow and lend at the same conditions as firms – a
“perfect world “ assumption (Modigliani and Miller, 1958).
As no such world exists – colourfully illustrated by the recent financial crisis causing financial markets characterized by what at the least can be described as “friction” – companies spend much attention to their capital structure (Berk and DeMarzo, 2011). Today many believe that there is an optimum level of debt for any firm, when considering the cost of
Theories such as the Pecking Order Theory, by Myers and Majluf (1984), and the Trade-off Theory, by Campbell and Kelly (1994), are well known theories aiming at explaining firms’
decisions regarding debt or equity financing.
Trade-Off Theory
According to the Trade-off theory, a company’s choice of capital structure – on an efficient market with symmetric information – is irrelevant; the tax shields and the financial stress that debt entails influence the choice. Tax deductibility of interest-rate expenses, in combination with double taxation of dividends and profit, creates what is referred to as a ”tax shield” that lowers the firm’s tax-expenses. It therefore becomes more lucrative to have debt rather than being fully financed by equity. The value of the tax shield adds to the firm’s market value, ceteris paribus (Campbell and Kelly, 1994; Brealey et al., 2008). The financial stress that debt entails, both in terms of the factual costs that debt causes, as well as costs that are harder to measure, such as lower market confidence in the firm, affect the optimal leverage for a firm.
The optimum leverage ratio can vary, but firms with more liquid and safe assets and large taxable incomes generally should aim for a higher leverage ratio; whereas less profitable firms with risky assets should finance themselves with a higher degree of equity. This would explain why firms such as real estate companies have high leverage ratios, and high-tech firms have lower leverage ratios (Campbell and Kelly, 1994; Brealey et al., 2008).
Pecking Order Theory
The Pecking-order theory has its foundation in the informational asymmetry that exists between a company’s CFO and the general market regarding the company’s risk exposure, values and opportunities. This asymmetry affects the company’s choice between internal or external financing and creates a “pecking-order” of financing choices, decided upon by the costs of the alternatives. Internal financing is the primary choice in this theory, followed by investment of accumulated profits, new loans; and lastly, new infusions of equity. This final alternative is regarded as a last resort when the company has exceeded its debt capacity – once the financial costs have become to high. If investors are rational, the company will always choose new debt over new equity, due to the signals that a new issue of shares sends to the market: an issue of new stock will cause mistrust concerning the true value of the company amongst market participants as they are aware of the informational advantage the company’s CFO has over them. Due to these concerns the issued stock will subsequently sell
According to the Pecking-order theory, there is no stated optimal mix between equity and debt as there are two types of equity available: internal financing, the most preferred and at the top of the “pecking-order”; and added financing by the owners, the least preferred option and at the bottom of the “pecking-order”. This explains why profitable firms borrow less: they don’t need external financing when their needs are covered higher up in the “pecking-order; in contrast to the Trade-of theory that states that firms aim to have a lower leverage ratio (Brealey et al., 2008). For firms to be able to stay at the higher levels of the “pecking-order” – consequently avoiding having to add new equity – firms create so called “financial slack”
during good years with high profits and low investment needs. This “financial slack” can be in the form of liquidity, such as assets and cash, as well as access to the loan market and bank financing (Brealey et al., 2008).
Market Timing Theory
The Market Timing Theory can be defined in two ways, one being Myers and Majlufs (1984) definition, which states that the informational asymmetry between the company and the market causes the company to take advantage of overly optimistic and overly pessimistic markets when determining the company’s leverage ratio. This is done by issue of equity when stocks are overpriced and by issue of loans when stocks are undervalued (Barker and Wurgler, 2002). The other definition of market timing is that the company acts according to macro economical conditions that are correlated with the cost of capital, exemplified by risk premiums or cyclical risk conditions (Faulkender, 2005).
Real Estate Capital Structure Theory
Even though corporate capital structure is one of the most researched subjects in economics;
little has been done in the field of real estate companies. There are, however, a few scholars whom have studied the subject (Howe and Shilling, 1988; Gau and Wang 1990; Bradley et al., 1998; Capozza and Sequin, 1999; Brounen and Eichholtz, 2001; Brown and Riddiough, 2003; Feng et al., 2007; Giambona et al., 2008), but unfortunately most cover the American market; and foremost Real Estate Investment Trusts (REITs), which are under somewhat different judicial conditions, and are taxed differently than ordinary real estate companies. An example of this would be that Howe and Shilling (1988) found that due to their tax exempt status, REITs should have a capital structure with minimal, or no, debt – an irrelevant finding to most Swedish and European real estate companies. An interesting discovery by Brown and Riddiough (2003), however, although related to REITs, is that due to the fact that the cost of
status”; firms on a pursuit of an ideal capital structure, should try to optimizing their debt structure to enable them to receive an investment grade rating (BBB-) and thusly minimize their financing cost. They consequently found that public debt issuing REITs tend to cluster just above investment grade ratings (Brown and Riddiough, 2003). Brown and Riddiough (2003) also suggest a linkage between REITs’ average debt maturity and its lease structure, as the lease maturity structure is of great importance to real estate owners’ future incomes and clearly a strategic operational decision. Giambona et al. (2008), on the other hand, suggest that this may not be the case: long-term commercial real estate leases usually contain some form of inflation protection, as well as a protection against escalading operating costs; while the matching of short-term leases and short-term debt increases both the cost and the risk of re-financing; hence, minimizing the importance of matching maturities. They also suggest that factors that effect market interest rates and the ones that change the rent equilibrium differ, along with the fact that short-term leases also increase the option-value for the parties involved – adding to their previous notion (Giambona et al., 2008).
A non-REIT-related study is Gau and Wang (1990) whom have studied real estate transactions in Vancouver, Canada, and concluded that transaction-based debt levels for property companies are effected by: borrowers capital constraints, non-debt tax shields, the absolute cost of debt finance and the cost of financial distress (Gau and Wang, 1990).
Brounen and Eichholtz (2001) studied the stock price reactions to announcements by European real estate companies to issue both debt and equity. Their study further fuels to the previous research in the field: an announcement of debt issuing is followed by a nonnegative price reaction, although modest, and an announcement of equity is exceeded by a significant negative price reaction (Brounen and Eichholtz, 2001). When comparing the different European countries they find that companies subjected to higher corporate taxes receive a more significant negative price reaction when announcing the issuing of equity – in line with the previously mentioned trade-off theory (Brounen and Eichholtz, 2001).
A recent study of Asian real estate developers and their use of bonds as a source of financing by Lam et al. (2011) explores much of what our paper aims to cover, although in a Swedish context and regarding real estate companies. They discovered that property developers access the bond market as an alternative source of financing, due to competitive pricing offered by the capital markets, as well as an increasingly regulated loan market (Lam et al., 2011). The study finds that larger developers have a wide array of available financing sources due to strong balance sheets and good credit ratings, whilst smaller developers still only has access to private equity and bank debt as financing through bonds is less accessible for smaller companies due to legal fees and fees incurred to obtain credit ratings – as institutional investors normally only invest in investment-grade bonds. (Lam et al., 2011). Lam et al.
(2011) mention several aspects of interest regarding the choice of source of financing. For example they mention that the relationship between bank and lender brings the banks closer to the customer/lender, in contrast to financing through the capital markets where bondholders and issuers seldom meet. On the other hand, banks condition loans with rather restrictive loan covenants, while also monitoring the borrowers closely, and thus have a great influence on the lender. In contrast, bondholders are usually less involved and have limited powers to influence management (Lam et al., 2011).
3.2 Risk and Risk Management
There are many risks associated with real estate financing, whereas the most severe risks are:
re-financing risk, interest rate risk and credit risk; but other risks, such as, market risk and liquidity risk are also important factors. Subsequently, the management of risks are of utter most importance to real estate companies, and of course their investors as well. During the past years many different form of instruments, so-called derivatives, have been introduced as a way of protecting oneself of the aforementioned risks – among others – and are today being utilized by both multinational companies and private investors.
3.2.1 Re-Financing Risk
Our definition of re-financing risk is the risk of a borrower being unable to re-finance an existing debt, or being unable to re-finance existing debt at favourable conditions.
3.2.2 Interest Rate Risk
From the perspective of a borrower our definition of interest rate risk is the risk of increased debt service costs caused by increasing interest rate levels.
From a bond purchaser perspective interest rate risk is the risk of value changes in the bond, due to changes in interest rate levels caused by the inverse relationship between interest rate levels and bond prices.
3.2.3 Credit Risk
Credit risk is the risk the lender faces of not getting part of, or the entire, principal loan amount repaid; as well as the risk of not receiving the debt service payments as expected. This risk is closely related to investors’ expected return, as credit losses causes return to fall below the expected return.
3.2.4 Liquidity Risk
Liquidity risk refers to the risk of not being able to sell an asset at its true value because of low market liquidity (Riksgälden, 2011)
3.2.5 Market Risk
Market risk refers to the risk of losses connected to changes in value due to market prices and market volatilities differing from their estimated values (CEA, 2007).
3.2.6 Hedging
Hedging in finance refers to the purchasing of financial instruments, products or assets in order to protect one’s investment against various types of risks. The most common hedge is by using different types of financial derivatives. Campello et al. 2011 found evidence that advocates that hedging both reduces companies’ cost of external financing, as well as eases their investment process as they get lower interest rates and more favourable, or non-existing, capital expenditure restrictions, compared to non-hedging companies (Campello et al. 2011).
Derivatives
A derivative is a security whose value depends on one or more underlying assets. It is a contract between two or more parties, and its value is affected by fluctuations in the underlying assets (Nationalencyklopedin, 2012(b)). Derivatives are regularly used as instruments of hedging, but are also often traded for speculative purposes. Common examples of underlying asset classes of derivatives are: stocks, bonds, currencies, market indices and interest rates. These take the form of stock options, futures and swaps. Interest rate swaps and interest rate caps are the most common forms of interest rate derivatives used to manage interest rate risk – and are commonly utilized by real estate companies.
Interest Rate Swaps
An interest rate swap is an exchange of interest flows between two parties with different interest rates. This allows for changes of the interest rate (fixed or floating) without change of the underlying loan.
Interest Rate Caps
Interest rate caps are purchased warranties of a maximum interest rate on a floating-rate loan designed to protect against sharp increases in interest rates. It can be seen as a more traditional insurance against interest rate risk that the buyer pays a premium for.
Interest Rate Floors
Another form of interest rate derivatives are interest rate floors: an interest rate policy with the same structure as caps, but against falling interest rates, with a minimum interest rate stated.
Floor can be used as hedging instruments to protect an investment with a guaranteed minimum rate of return (Nordea, 2012(a)).
3.2.7 Bond Ratings
Rating agencies rate bonds, therefore indicating their credit quality by assessment of the issuing company’s ability to repay the bond’s principal and interest in a timely fashion.
Below listed are the bond ratings of long term debt assigned by the three major rating agencies, excluding minus (-) and plus (+) signs that may be added to the grade by Standard
& Poor’s and Fitch (e.g. BBB is a higher grade than BBB-), and excluding the numbers 1-3 that may be added by Moody’s (e.g. Aa1 is a higher grade thanAa2):
Table 1: Ratings
Moody’s Standard & Poor’s Fitch
Investment Grade Aaa AAA AAA
Aa AA AA
A A A
Baa BBB BBB
Non-Investment Grade Ba BB BB
B B B
Caa CCC CCC
Ca CC CC
C C C
C D D
Source: Long, 2011
3.2.8 Real Estate Risk Management Theory
Risk management in relation to choices of financing is a central issue for real estate companies, and one of the most severe risks that arise with any type of debt financing – and especially real estate, due to high leverage ratios – is the interest rate risk incurred by the borrower. Interest rate swaps are, according to Li and Mao (2003), one of the financial derivatives that are most commonly used to manage this type of risk; since they give companies the benefit from short-term borrowing, while at the same time eliminating the interest rate risk associated with this type of borrowing (high transaction costs, lack of protection, etc.) (Li and Mao, 2003).
