||In my first year as Finance Director, I am delighted to be able to report record profits before tax of £508.7m (£368.1m in 2005) for the year. Total returns, at 15.5% (15.1% in 2005), were their highest for seven years. Grosvenor’s weighted average cost of capital for 2006 was 7.2% (7.5% in 2005), resulting in returns of 2.15 times our cost of capital (2.0 in 2005).
While annual returns and profitability are important, we also focus on returns over the medium and long term, measured against our cost of capital. Over the last 10 years returns have averaged 13.5% and our cost of capital has averaged 9.7%.
EARNINGS Revenue profit, which we use as our measure of underlying performance, was a loss of £107.9m (£46.6m profit in 2005). Excluding the provision for Liverpool One, revenue profit increased to £62.0m (£56.6m profit in 2005). The income statement provision for Liverpool One was £169.9m. A related gain of £29.9m, being Grosvenor’s share of revaluation gain arising to the Liverpool investors, is taken through reserves, giving a net Grosvenor loss for the year on the project of £140.0m.
Grosvenor Fund Management celebrated its second year of operation as a separate business by generating an operating profit. This was due to performance fees, and leaves the medium term challenge of achieving stable profitability irrespective of such fees. An important element will be attaining critical mass in terms of the level of funds under management and increasing the number of large “flagship” funds.
Before the impact of Sterling’s appreciation, each of Grosvenor America, Grosvenor Continental Europe and Grosvenor Australia Asia Pacific delivered an increased revenue profit.
Profit for the year was flattered by significant revaluations, driven principally by the continuing attractiveness to investors of property markets. Disaggregating underlying performance from market movements, particularly for our unique London Estate assets, is difficult. However, with the increasing number of relatively representative property market indices in many of our markets, we will be able to identify more accurately the value added by our teams, separate from general market movements.
CORPORATE ACQUISITIONS During the year we completed two corporate acquisitions. In February Grosvenor Continental Europe acquired control of a further 17% interest in Sonae Sierra for a cost of £157.3m (Euro 228.9m). Goodwill of £32.1m, principally in respect of deferred taxation, is recognised in respect of this acquisition. In March, Grosvenor Fund Management acquired Legg Mason Real Estate Services Inc (now Grosvenor Investment Management Inc) for £4.6m
(US $8.5m), excluding co-investment interests. No goodwill arose on this transaction.
PROPERTY ACTIVITY Assets under management have increased by 20.8% to £11.0bn, reflecting the evolution of our fund management business and the increased shareholding in Sonae Sierra.
Our Operating Companies made acquisitions and incurred development expenditure totalling £1.3bn in 2006, and made sales of £800m. The principal property transactions are described in the Operating Company reports which follow.
LIVERPOOL ONE Grosvenor has always been committed to delivering this prestigious project to the highest standards. This commitment, coupled with the inherent uncertainties in cost estimates at the early stages of design, has led to development costs now being expected to exceed substantially the original estimates. The impact of the development cost guarantee, given by Grosvenor to investors, is that costs in excess of the guarantee level fall for Grosvenor’s sole account. A provision is now required for all of these expected costs.
Liverpool One is now in its later stages of construction, so many of the financial uncertainties in the project have been resolved. The financial outcome of the project is now more certain than even a few months ago and we are confident that investors in the project, of which Grosvenor is one, will experience good returns.
RISK MANAGEMENT In the light of experience on Liverpool One, Grosvenor Britain & Ireland is reviewing its processes in relation to large scale developments. A number of changes have already been made.
An important part of our process for improving risk management and business practices is cross-Operating Company forums. The Group Finance Board, which comprises all regional Finance Directors and other senior finance staff, meets two to three times a year with a wide finance agenda. Other less formal cross-Operating Company forums exist for other key specialisms, such as property development. We are now focused on identifying opportunities for “better practice” throughout the business via a formal framework.
TREASURY At year end net debt was £204.1m, comprising cash of £455.4m less debt of £659.5m. As the proportion of the Group’s assets invested outside Britain & Ireland grows and the volume of property transactions increases, it has become clear that management of the Group’s treasury operations could be more efficient on a Group, rather than Operating Company, basis. From 2007 we are therefore introducing a Group-wide co-ordinated approach to treasury. Immediate benefits will include spare cash in one region becoming available for use elsewhere in the Group, avoiding the need for additional debt, and a more strategic approach to debt financing.
Our “relationship” approach to banking has served us, and our banks, well. The operational benefits of working with lenders who understand our business and culture, and value their relationship with us for the long term, more than outweigh any modest additional interest costs.
The Group monitors its “resilience” to potential general falls in property market values. We define resilience as the extent to which the Group’s property interests could fall in value before Holding Company financial covenants would be breached, assuming no property sales or debt repayments. At year end resilience was substantially in excess of our minimum level.
The Group has substantial liquidity, with some £672.8m of spare funds being immediately available for Group opportunities. Our liquidity and resilience mean that if there were to be a substantial correction in the property markets, for us “the sooner the better”.
||PROPERTY DERIVATIVES We have monitored the development of the property derivatives market with interest. I see significant opportunities for Grosvenor from an efficient derivative market. A deep liquid property derivative market would facilitate the Group’s asset allocation optimisation and would present new product opportunities for our fund management business. We are now developing systems to enable efficient property derivative execution and we undertook our first small test trade in the latter part of 2006. We will continue to work with the industry and banks to facilitate a market suited to property investors and will develop our capability to take advantage of opportunities as they arise.
CAPITAL ALLOCATION Factors of increasing importance, in our process for allocating capital between our regional Operating Companies, include quality of life, demographics, city growth and climate change. Evidence of climate change is overwhelming and the potential consequences, if action is not taken, dramatic. Property markets will not wait for climate change; they will be affected much earlier by policy initiatives in response to potential climate change.
Grosvenor’s economic interest in property in each region and country at 31 December 2006 is shown below.
Geographical Distribution of Portfolio – 2006
PROPERTY MARKETS As a long term investor, Grosvenor is less reliant than others upon predicting property market cycles. Our focus is on individual property investment returns and associated risks, with equity generally fully invested. We manage the impact of the cycle on our business, by ensuring sufficient resilience and liquidity when the market is high, and seek to position the Group to take advantage of corrections whenever they arise. The price of this additional security is forgoing enhanced returns through very high gearing levels when markets perform well.
Much has been said about the state of the market and if, or when, a correction might arise. If a bubble is defined as irrational pricing, then I do not see that the time when a bubble bursts can be predicted rationally. All that you can say is that bubbles burst. The harder question is whether there is a bubble at all. When analysed in simple interest rate/return terms, property prices look high, yet when considered in terms of equity available for investment, while demand pressure has fallen, significant uninvested capital awaits suitable opportunities. There is probably no bubble, but one thing seems clear – risk is too cheap.
Of greater concern is that the current hype in the international property markets has attracted capital from a broad range of investors, including retail investors, some with little or no property experience. As prices rise the potential for significant reversal of market fortunes increases, leaving the retail investor, who requires most protection, the most exposed.
SYSTEMS 2006 saw the rollout of MRI, our new property management system, to most of our offices outside Britain & Ireland, and the implementation of an electronic invoice authorisation and payment workflow system in Britain & Ireland. For 2007 we plan an early overhaul of Grosvenor’s web presence, the introduction of a treasury system in our principal offices and a review of human resource systems.
FINANCE TEAM Our finance teams have worked hard alongside property colleagues, providing financial guidance and support as required for our expanding operations. In addition to the corporate acquisitions I have mentioned, they have supported the opening of new offices in Madrid and Milan, and reorganisations of the Americas and Britain & Ireland teams, as well as several management changes. We have welcomed several new members to the team, including Robert Davis who joined as Finance Director of our fund management business in May.
Finally, on a personal note, I have experienced a delightfully smooth transition from Finance Director of our fund management business to Group Finance Director. This was assured by the guidance and support of my predecessor, Jonathan Hagger, to whom I am most grateful.
Group Finance Director
15 March 2007