Breadth of vision and forward thinking are essential components of risk management, as is a sensible workplan. Stephen Ryan reports

T he past seldom obliges by revealing to us when wildness will break out in the future. Wars, depressions, stockmarket booms and crashes...come and go, but they always seem to arrive as surprises. After the fact, however, when we study the history of what happened, the source of the wildness appears to be so obvious to us that we have a hard time understanding how people on the scene were oblivious to what lay in wait for them." From Against The Gods - The Remarkable Story of Risk, by Peter Bernstein.

Bernstein's comment, written in 1996, is of direct relevance today to all investors in commercial property. As we grapple with unprecedented and in some cases catastrophic losses in certain property markets it is worth asking: could better risk management have avoided, or at least mitigated, some of the pain?

This is not just about being wise after the event - it is about identifying what lessons need to be learned (or re-learned) and applying them diligently, even after the current market turmoil has passed.

This article does not attempt to summarise all points of good risk management (there are too many for any single article) - instead, it hopes to provoke some new ways of thinking about this important area.

Introduction
Risk management is part of sound investment governance and as such is carried out against the background of the statement of investment objectives and the governance charter. But beware: the investment objectives themselves may create risk. For example, where there are multiple objectives, it may not be possible to achieve them all at certain points in time, unless there is a clearly agreed hierarchy of objectives in place.
What are the key risks associated with these
objectives?

It is tempting to reel out a long and potentially mind-numbing checklist of risks but it is more useful to identify some which are perhaps less obvious:
 

Does our real estate risk management system pay sufficient attention to signals from the wider capital markets? The bond and property derivative markets in particular can be a rich source of data but are often ignored in favour of more established valuation measures; In a multi-asset portfolio, do our risk management systems link up across asset classes? Are tenants in our property portfolio also represented in either our bond or equity portfolios? For example, an investor could have multiple exposures - as landlord, bond holder and shareholder - to a single entity; In our value added and opportunistic closed end property vehicles, are the fee structures (designed with alignment of interest in mind) unsuitable to a down market? Are the fund managers so far ‘out of the money' (in the sense of being behind their performance fee hurdle rate) that they will lose interest in managing the portfolio? Have we ignored the insights from behavioural finance?

Behavioural finance example: The endowment effect
The endowment effect (also known as divestiture aversion) is the hypothesis whereby a person places more value on something once their property right to it has been established. People may demand a higher price for a building they already own but put a lower price on one they do not yet own. In a property downturn fund managers may exacerbate illiquidity problems by refusing to part with buildings they own. Armed with this knowledge, investors may be in a better position to understand and therefore deal with future liquidity events.

Who will monitor these key risks?
Once the key risks are identified, who is responsible for monitoring and managing them? Is this something for the trustees only, for the investment consultant only, for the fund manager only (whether in-house or otherwise), or something for all three. If risk management falls to all concerned parties, does each one know his role and is each player equipped to play it?

It is critically important that the overall delegation of risk management is itself sound and regularly reviewed, to make sure that all risks are in fact monitored by someone, and to keep a watchful eye for new risks arising.

Here are some useful governance tips. One is obvious: make sure sufficient time is devoted to the task. How much time is enough? Experience will teach us but as a rule of thumb assume you will need twice as much time as you originally allowed for.

Another governance tip may be less obvious: make sure you vary the data (metrics) that you are using to monitor risk. ‘Metric fatigue' sets in when the same data sets and measures are discussed in the same way and at the same point at every meeting. Whatever the data is (and the property world is not short of key metrics) try to keep your analysis of it fresh.

Consider focusing on a pair of key metrics at one meeting, and another pair of key metrics at the next meeting and so on throughout the year, so that every key measure gets discussed in depth at least once a year. And if time cannot be found to interrogate each piece of data at least annually, then query why you are collecting it at all.

What is our backup plan if one or more of the key risks materialise?
Contingency planning is important. Reacting after the event has happened is not likely to deliver as good a solution as one agreed in advance, not least because decision making is now made under severe pressure. The need for a contingency plan is particularly acute in cases where the risk suffered is widespread or systemic because in those situations you are effectively competing for a solution with other stricken investors.

Let us take manager underperformance or style drift as an example of a key risk. As part of their contingency planning, investors might find it useful to have a ‘substitutes' bench', to use sports jargon - that is, a list of pre-approved managers who can replace a terminated manager.

Another example is liquidity risk and how it might work at property portfolio level. What if investors in a diversified pooled property fund cannot fully redeem their holdings because the property market transactions have stalled? Solutions may be available in the secondary market or the derivatives market but does our trust deed permit us to access such markets?

Conclusion
Like Humpty Dumpty, many property markets have had a great fall. The good news is that, unlike in the nursery rhyme, it will be possible to put Humpty Dumpty back together again. The bad news is that Humpty will, inevitably, have another great fall at some point in the future. Good risk management can help ensure that the next time this happens, you will be well prepared.

Stephen Ryan is a senior consultant at Mercer