Risk management was sometimes disregarded during the feeding frenzy of the boom years; today debt, liquidity and tenant risk are in sharp focus. Christine Senior reports
Ask any real estate investor or manager about their risk perceptions since the downturn and the words leverage, gearing or debt will come up pretty quickly. There is little dispute about the major element of risk that has increased in importance in recent months. Leverage was the factor that pumped up returns to remarkable levels in the good times, but dragged down performance to the depths in times of trouble.
Concerns about risk have drawn investors back from the riskier more speculative areas of property to the comfort zone of the well established, safer, more reliable territory of developed markets, higher quality locations and blue chip tenants. All these have increased in importance. But in the overall scheme of things it is leverage that has impacted portfolio returns, and for the foreseeable future leverage is likely to remain centre stage.
John Danes, head of UK research and investment strategy, Aberdeen Property Investors, thinks that borrowing is not going to go away as an important issue for a while.
"I think it will take many years for banks to rebuild their balance sheets and the amount of debt we have been used to over the past five years will not be available. It may take several years for it to come back. Many UK banks have an element of state control and will be under pressure from the government to channel new lending to the residential sector and to small businesses. Commercial property lending may go to the back of the queue."
Refinancing existing loans rather than making new loans will be another priority for banks, he says. "I think the old fashioned equity-based property investment is going to become much more the dominant type of property investment in the short to medium term."
Even if borrowing were easily available, investors have had their fingers burnt through leveraged property deals and are now much more wary of debt-financed property funds. At the development end of the property spectrum the problems have been the most significant. With no income from rents, investors have had difficulty servicing loans and faced breaches of loan covenants. The downturn has brought home the malign effect of leverage in falling markets.
"Investors have been reawakened to the danger of operating in real estate with leverage," says Harry Humble, investment director of real estate, Standard Life Investments (SLI). "Appetite for leverage was driven in the upswing by the degree investors perceived it would enhance absolute return, which is natural as the market rises. It also significantly enhances the negative returns on the way down. You are taking the same level of property risk, you're just enhancing significantly the volatility within your portfolio by running with higher leverage."
As a consequence of this, interest has shifted away from leveraged strategies to the more solid core and core plus investments. But even perceptions of these appear to have changed. Geert de Nekker, director of real estate at Cordares, in considering the total leverage in his portfolio, is revising his definition of core funds away from INREV's formula to include a reduced permitted level of borrowing.
"According to INREV's definition of core funds there is leverage up to 50% in it, but we believe for core funds the leverage should be up to 30%," says de Nekker. "And we are going to make a new definition for our total portfolio what percentage of core funds should be in it, then value added, then opportunistic. The focus will be on core. The total percentage of leverage of at portfolio level should be at a lower level than now, dramatically lower."
Humble at SLI confirms this trend away from more leveraged strategies back to core. He says: "Almost universally we find investors see it as a good opportunity to buy core real estate at relatively attractive prices, by core that means stabilised income streams. There is a lesser appetite for property that has vacancies or short term lets, or for development projects."
The flight to safety is also manifest in the reduced appetite for the less developed property markets of central and eastern Europe and the increasing attraction of the comfort zone of western markets. Much of the interest in Central and Eastern Europe was driven by high prices and lack of opportunities in Western Europe or the US. But there has been a complete reversal in fortunes, so the outlying markets have become relatively less attractive.
"Today it is possible to buy very well in London or Paris, so why would you go to Bulgaria to get a comparable return," says Humble. "You will see in a 12-18-month window that it is going to be more difficult to raise capital for central Europe. Certainly for BRIC countries and emerging markets it is a more difficult story today. That is driven as much by the fact there are attractive returns to be found in mature markets. Therefore, you don't need to go abroad to seek that risk premium."
Another huge concern for commercial property investors in these times of rising company bankruptcies is the quality of their tenants - the type of tenants, the economic sector are they operating in, what is the chance they will still be in business in six months or a year's time.
"Currently many investors are shunning assets because they have concerns that the tenants could go bankrupt or could be falling behind with rents," says Arnaud Prudhomme, global CFO and company secretary, AXA REIM. "You need to have tenant performance monitoring, you need to have lease expiry profile, you need to have a clear view of the strength of the covenant, the exposure per sector of your tenants. You have to have a view of litigation risk. All these need to be monitored."
These risks are not necessarily straightforward. Eighteen months ago a blue chip AAA rated international bank or financial institution might have been considered a secure and reliable tenant. Nothing can now be taken for granted.
The same goes for the managers investors are dealing with. A manager who is part of a bigger global institution and backed by what was considered a strong parent would in the past have inspired greater confidence. But things have changed. Investors are concerned about manager risk: do they know the strength of those they are dealing with? Will they be around for the long term?
Some perceptions of risk have been turned upside down. Richard van Ovost, head of international real estate, Mn Services, illustrates how his thinking has changed. "We have over 100 partnerships all over the world and we were very happy to have partnerships sponsored by large institutions or a bank. You were not so happy investing as a seed investor with three young guys starting their own new business. You always felt a bit worried. Now those three guys have built a company with 12 people and 12 computers and a very cheap office and they are doing very well. They are able to move very swiftly around the market, making use of market circumstances. Where we have the most problems in partnerships are those where the mother company used to be a very strong or listed company that is now in deep trouble. It's a fact of life - you see risks where you didn't see them before."
Liquidity risk in funds is one area that has attracted a lot of press attention, particularly in relation to retail property funds where private investors have found themselves having to wait six months or longer to get their money back. Institutional investors too have suffered when so called open-ended funds have been locked up, denying them access to their money. In other cases managers have slapped a redemption fee on withdrawals.
Property of course is an illiquid asset and it takes time to sell assets to provide the liquidity to cover redemptions. Property fund managers can make funds more liquid, but at a cost.
"One way is to have a high cash weighting but that is a drag on performance," says Peter Mackaness, property investment specialist at Threadneedle. "Or you can go into listed securities. You have a fund which has some direct property assets and some listed securities. The theory is that listed securities are liquid; the problem is that they are very volatile as well."
Given the catalogue of risks to be monitored, it has become more important for investors to ask more questions, to get greater transparency from their managers. They are using all the methods at their disposal to keep abreast of their managers' action on risk management. This includes more frequent contacts and more thorough research, talking to and meeting more regularly with managers and using any other sources of information they can lay their hands on.
This is also part of consultants' manager rating process. Jane Welsh, senior investment consultant at Watson Wyatt, describes how the firm investigates managers' risk management capabilities.
"When we are talking to managers, we are more focused on not only whether they have problem investments in their portfolio, but what they are doing about it. What active steps are they taking to try to address the issues? Do they have enough cash to solve these problems? It's not just looking at whether they have great properties in their portfolio but also what is the capital structure and how they are managing the risks?"
Investors want to find out more about the risk management process managers have in place, says Prudhomme, at AXA REIM. "Investors realise that if risk is not properly managed it has an impact on performance and the value of the asset. And they realise that some investment managers might not have the tools necessary to manage these risks properly, either because they have under-invested in risk management tools, or because they have had a piecemeal approach to risk management, splitting the risk into interest rate risk, liquidity risk, tenant risk, and so on, but not having an aggregated view of all the risks and their interaction. And there may have been too much reliance on quantitative tools only, instead of introducing some qualitative elements.
"In qualitative assessment what is key is that risk management is combined closely with performance management - making sure in the investment process you have clearly identified who is taking decisions that potentially have a material impact on the performance, having people who are accountable, to set a balance between the business objective and the risk of the fund. It's a question of common sense in the way you manage your investment."
As tenant risk is high on the risk management agenda, checking out tenants' financial standing is a key priority for managers.
"The key risk is void risk for properties at the moment, the risk of the tenant going bust and not being able to pay rent," says Danes. "We make sure tenants we make lettings to are in good financial health. We do that using credit agencies, and forensic accountants if necessary."
For Mn Services, having a blend of different investment strategies in its portfolio has been a means of reducing risk. Some funds which started out as opportunistic funds, as they have matured their risk profile has moved towards value added or even core, and some of these were not sold as planned last year.
"So we have somewhat more real estate on the balance sheet in those funds than we planned, but on the other hand we are not hit so hard by high leverage and by markdowns of real estate," says van Ovost. "We do have a lot of funds that have matured already so we have a blend of opportunistic real estate and former opportunistic real estate and it helps risk management of the portfolio enormously."
Diversification is also cited as a risk management strategy by Ville Raitio, investment manager at ATP Real Estate. At the portfolio construction level, diversification is in investment style, managers, country, sectors, and through monitoring the level of gearing. But at the pre-investment stage with a fund manager another form of risk management is through rigorous due diligence procedures, says Raitio.
"In the pre-investment phase," he says, "it's important to go through thorough due diligence so whatever the structure you are investing in meets your needs from the portfolio, but also that the level of corporate governance reporting and other functions are at a high quality level. Once you have signed up to a product you can't change it after the fact, so you have to focus on this before investing."