Once a source of relatively easy returns real estate is now proving more challenging. This brings the subject of risk management to the fore. Lynn Strongin Dodds reports

Property investors have been spoiled. For the past four years, particularly in the UK, prices have gone through the roof. Today, though, the outlook is not as bright and the risk management equation is changing. Managers are going back to basics and placing more emphasis on the quality of the tenants and rental incomes.

This is especially true in the red hot UK market, which has been one of Europe's most buoyant. Few expect a significant property slump but instead foresee prices cooling.

The general consensus is that UK commercial property returns - which combine rental income and capital growth - are to halve this year and in 2008, after four outstanding years in which the market has averaged 18-19% growth per year.

As a result, rental income is expected to be the main driver behind all future property returns. As Peter Damesick, head of UK research and consulting at CB Richard Ellis, notes: "The dramatic compression in yields has ended and even begun to reverse in some parts  of the property market in response to higher borrowing costs and investors' reassessment of risk. The market is likely to become more discriminating with regard to the quality  of investment stock, as rental income growth  becomes a more important driver of performance."

Overall, risk management in real estate is a relatively new phenomenon. The property crash of the early 1990s followed by the TMT debacle, as well as corporate scandals such as Enron, Worldcom and Parmalat, forced the financial services industry in general to become more disciplined. Property investors also became more savvy and insisted that the same rigorous standards, due diligence and strict corporate governance being implemented in the equity and fixed income world were also applied to the property arena.

John Gellatly, director, head of global fund of funds at BlackRock, says: "Investors have a greater understanding today of property as an asset class. In the past there was over exuberance and people did not fully appreciate that real estate is a lumpy, illiquid asset whose value can fluctuate. In terms of risk, real estate is far more complex than other asset classes. You are not just buying a building but a multi-dimensional asset. Over the last few years, a whole set of tools have been developed to provide a sophisticated risk management analysis of the asset class."

Despite the advances, the lack of transparency remains one of the biggest challenges facing the industry when assessing the risks. One of the main differences between real estate and other asset classes such as equities and fixed income is the information available, according to Quentin Burgess, head of fund administration at AXA Real Estate Investment Management. "Equities and bonds are well researched and transparent investments trading on a public market. Real estate which has only recently entered the real estate investment trust (REITs) market in the UK is still in its infancy. The process of due diligence is much more bespoke. The nearest asset class is private equity, which is also illiquid, unquoted and requires a more mid- to long-term time frame."

According to Gerry Blundell, European director of strategy and research at LaSalle Investment Management: "The starting point is to evaluate the individual assets in a portfolio and estimate the bundle of risks that the portfolio represents. A well balanced portfolio will have a diversified set of risks. Then decide whether the risks are being adequately compensated for. For example, if a retail warehouse is on a 4% yield and the investor's required return is 9%, what are the chances of rental growth bridging the gap."

Of course, fund managers examine different criteria depending on the nature of the funds. Patrick Kanters, managing director, real estate, Europe, Asia Pacific at ABP, Europe's largest pension fund and a long time indirect property investor, notes that its core, value added and opportunities as well as regional funds have separate risk/return profiles.

The level of gearing has recently become a hot topic due to rising interest rates. Several funds took advantage of low rates to enhance their returns. In the last five years, returns in the UK have been 15-18% and the cost of money between 6-7%. However, the Bank of England has raised interest rates three times since last August, and although it is unlikely that investors will lose money, returns could be depressed in the future. Fund managers, though, are still willing to take a risk if it justifies the return. Patrick Kanters, adds: "The amount of leverage is important but in certain circumstances we will not shy away from it if it makes sense from the specific real estate strategy's point of view. For example, in our opportunity funds with short holding strategies, it might be appropriate to take on high gearing levels. However, in general we are much more aware of leverage and are paying close attention to the cover ratios."

Naturally, diversification of the fund and the spread of risk across products - residential, retail, office, opportunistic - and geographical location are important factors. Fund managers are also being scrutinised with a much more discerning eye as property prices become more volatile. After all, it is easy to perform in booming markets, but investors want to ensure their managers have the acumen to select the right properties, sectors and locations in less benign conditions.

According to Bart Coenraads, chief investment officer real estate at Fortis Investments: "Another question to ask is whether the fund manager can invest the money the fund has raised. Raising capital has not been that difficult over the past couple of years, investing that equity will be the biggest difficulty. Regarding the universe of funds, there is currently ample supply in the market but investors want to know whether they can find suitable products that produce the returns they require and also at what sort of risk. Some players will want to increase risk in their strategies to maintain their targeted returns. This is not always beneficial to the investors so they need to monitor it."

The spotlight also shines more brightly on corporate governance and the risks attached to a poor governance framework. The areas that most institutional investors highlight are the potential conflicts of interest as well as the commitment of the fund managers. Many investors, for example, do not believe that the fee of the fund managers should be linked to the net asset value, although many are rewarded in this manner. Instead, a performance-related fee is favoured.

Kanters notes: "Corporate governance is one of the most important issues. The fund's interest must be truly aligned with the institutional investors. We also want to know how the decision-making process works and how conflicts of interest will be resolved."

Looking at risk management from a property manager's viewpoint, there is also a common check list to be trawled through. The order of importance might change, but the quality of the tenants, leasing arrangements, health and safety compliance, legal obstacles, market conditions and, increasingly, environmental issues are all included.
Against the current climate, it is no surprise that tenant quality has become paramount. Investors are not always interested in the household names but those who have the resources and balance sheet to pay the rent if trading conditions worsen. Also, in many commercial leases, the tenant can be liable for the cost of repairs and maintenance. As Gellatly notes: "One of the most important things to look at is whether the building is let out to the right tenant at the right price and at the right rent."

Fund managers are not only doing their own homework but are also turning to real estate managers and independent credit agencies to unearth a tenant's bad debt history. Simon Marx, head of real estate forecasting and analysis at Experian, a UK-based independent consultancy and ratings firm, confirms the trend. "Today, there is much more focus on the income stream that properties will yield. We are definitely seeing an increase in requests for our credit ratings on tenants to determine their default rates. Many of the tenants are small players or are part of a larger corporation and people want to know if they will be able to pay their rents if there is a downturn."

Lease arrangements are also high on the agenda. The UK is following the US and Europe and opting for shorter leases. Over the past 15 years, there have been considerable changes to the standardised commercial lease terms. According to figures from the Investment Property Databank (IPD), the length of leases have been falling with the average now standing at less than five years in 2005, down from 13 years in 1995.

Although tenants favour shorter and more flexible leases, institutions would prefer a minimum of 15 years. It is no wonder that investors have been attracted by the large pool of prime properties created by corporates selling their freeholds on a 25-35 year sale-and-leaseback basis, with minimum rent increases, (linked to the retail price index every five years). It remains to be seen whether the companies will regret this move or if investors paid over the top. Whatever the length of the lease, investors should concentrate on the rental reviews, whether there are break clauses and any other factors that might impede the property's income stream.

It should come as no surprise that legal risks have also moved up the risk scale, especially as the UK, and even Europe has become much more litigious. There  is a minefield of rules and regulations that real estate managers need to navigate. Burgess of AXA REIM comments: "When you are buying a building it is important to make sure that you have a strong contractual claim to collect the rent and have the ability to make rent upgrades. The building must also comply with all the planning and health and safety regulations."

Stephen Pyne, chief investment officer of ING Real Estate, reiterates this point: "You have to understand what the legal constraints are, the implications and how that might impact the price. For example, if there is a restrictive covenant it may mean that the building can only be used for commercial purposes and nothing else."

To cover all scenarios, property managers conduct detailed technical analysis and surveys before purchasing a property. The banks also insist on these types of report before agreeing to lend any money. As Burgess put it: "There is no ink on any bits of paper until all the due diligence is carried out. It is also important to do because if you breach any of the health and safety regulations it can cost a lot of money to rectify the problems or if someone sues."

The first step of course is to determine how structurally sound the building is and what type of repairs might be needed in the future. For a commercial building, this also covers a host of health and safety issues such as wiring, ventilation, windows and double glazing, floor space and dimensions, sanitary arrangements, lifts, disabled access, conditions of floors and traffic routes.

Sustainability has also become the new buzzword in property circles. Government policies and public opinion, coupled with studies revealing that around 45% of carbon emissions emanate from buildings, is putting the pressure on. This means that in future, environmentally friendly properties are more likely to command a higher price tag. Compliance, though, does not mean just adding a few solar panels or installing wind turbines. There are several major risks that could have a dramatic impact on building value and performance.

These include insurance, financing and the ability to attract and retain tenants. For example, global insurers are analysing their clients' requests much more carefully, particularly in light of increased threats of climate change and natural disasters. Banks may not be willing to finance buildings which do not meet the requisite codes and regulations. Environmentally aware tenants, on the other hand, may shun a building that is not fit for purpose in terms of sustainability.

Although the state of the building and the pedigree of tenants is critical, market risk is always important. "Investors should look across sectors and overseas markets in their search for diversification," says Blundell. "But they should not ignore the characteristics of their existing portfolio. If they have 50 properties but 90% of them are occupied by banks, putting 10% of their assets overseas will not solve the problem."

Knowing the local market and appreciating the cultural nuances is critical. Gellatly notes: "In the UK, for example, the pricing of shopping centres is not that much different in Manchester, Leeds or Cardiff. The criteria is based much more on the size of the centre and the strength of the tenant versus where it is located. In Europe, the property markets are much more fragmented and have their own trends."