It is an irony of investment that concerns about risk follow rather than precede crises. The irony is that markets are less risky after wealth-destroying periods than before them since prices are, by then, lower. This cycle is no exception although the speed and amplitude of the fall in values has been magnified by leverage. And as values have fallen, “risk” has again become an integral part of the vocabulary.
Risk analysis has come late to property, having had to wait for the creation of suitable historic time series. However, by 2000 an IPD/IPF survey indicated that the most frequently mentioned risk analysis tools were measures based on capital asset pricing model, measures of past volatility, etc. So at the start of the current cycle, most risk managers’ eyes were focused on past patterns of returns.
Meanwhile, a growing body of evidence was accumulating to suggest that return volatility significantly underestimates real estate risk and offers no diagnostic guide to managing it. So we had a risk management approach that looked backwards and, via the insidious efficient market assumption, provided a justification for light regulation.
At LaSalle Investment Management in the late 1990s, we built a series of measures about properties and portfolios which we believed reflected the future risk embedded in the asset. These ranged from the duration of contracted cash flow, covenant risk, income as a proportion of return through to simple concentration ratios. This approach, published in late 2003 as the Blundell Risk Web, became a standard part of the IPD report to UK clients. The risk web (see figure 1, below) illustrates 12 portfolio risk measures.
The basic idea is that risk cannot be eliminated without lowering returns to the risk-free rate. So the key job of the investment manager is to manage stock and select assets so as to develop a risk profile most consistent with the portfolio’s investment objectives. The risk web gave an instant visual check on the risk balance of the portfolio based on its current assets.
The portfolio depicted in the risk web below is over-exposed to the volatile central London markets and so has a lower yield and a higher development exposure, but these are compensated by lower risks on other spokes of the profile.
Since 2003, LaSalle has refined the risk web down to four key forward risk factors which drive expected returns (see figure 2, below). Each of the four are present in differing degrees in each property, portfolio or vehicle. They are modulated by the net cash position and by derivatives.
As economic circumstances change, different sources of risk become more important. Our analysis of yields in late 2006-07 suggested they were likely to rise by over 100bps. Although we did not know when, this led portfolio managers to accelerate sales, defer purchases, and to reduce leasing risk. As events of 2007 unfolded, every individual debt within LaSalle vehicles was reviewed and, where necessary and possible, new arrangements were put in place. Critical tasks included ensuring that leasing risk concentrations did not coincide with a refinancing event at a vehicle/portfolio level.
Using recent experience, we can boil down the key rules to two “don’ts” and two “dos”.
? Don’t forget about risk when the good times return (as prices rise so does the chance of decline).
? Don’t rely on rear-view black boxes when you’re concerned about the future.
? Do remember that investors need risk to generate better returns than the risk-free rate the key is to buy it at the right price.
? Do pay attention to newly emerging sources of uncertainty (such as climate regulations) because uncertainty is even more dangerous than risk.
