Covenant Strength and the Initial Yield: An Explicit and Calibrated Risk?

Under the traditional method of valuation, risk is implicit within the initial yield which is used to capitalise the net income into perpetuity. The yield is derived from the risk free rate, usually long-dated gilts, plus a risk premium (Hoesli and MacGregor, 2000). Where the risks are seen to be high, a higher risk premium should be added. Individual differences in the investments characteristics, such as covenant strength, are taken into account by subjective yield adjustments. The initial yield is obtained from sales comparables, with potentially only limited knowledge of the fine details associated with the transaction, such as the covenant strength default rating. This paper considers whether covenant strength risk is explicitly accounted for in the selection of the initial yield when valuing a commercial property investment, and if so, whether the associated risk premium can be directly calibrated to the credit score. The research extends previous work by the authors on Property Risk Scoring, which involves the analysis and scoring of the total risk of the property asset (Hutchison et al. 2005). his paper presents analysis of ICC credit scores of the top 25 retailers in the UK over the period 2002 to 2006, plus a case study approach to the covenant strength variability of two shopping centres to illustrate the key issues in calibrating the covenant strength risk premium when a composite initial yield is used. The paper also considers the manner in which covenant strength risk is reported to clients.