Beneath its apparent simplicity, the real estate sector is, in reality, highly complex. It stands out from other sectors in that it brings together a number of widely different professions – investors of all kinds which include bankers, developers, builders, managers, intermediaries, experts, etc. – and deals from many different fields – housing, commercial real estate, healthcare, logistics and hospitality. Some of its players operate as listed companies, while others have long been spared any form of regulation. The types of operations involved are equally diverse – buying, selling, managing, renting, building and renovation.
The sheer richness and variety of this landscape makes it difficult to establish common practices of risk management.
Progress in the area of good practices
Two major events over the course of the past twenty years have paved the way for decisive progress.
The devastating real estate crisis of the 1990s left French institutional investors deeply traumatised with an enduring distrust of this particular asset class.
Their disinterest caused prices to slump, attracting massive attention from opportunistic US and UK funds from 1995 onwards. These funds first introduced financial marketing to the sector, launching a process of financialisation whose impact would only be appreciated later, but that undoubtedly encouraged a more sophisticated approach to the question of risk.
In a paradox worth noting, the players most inclined towards risk-taking were the very ones who insisted on more prudent management methods: in-depth asset analysis, interminable due diligence processes entrusted to giant law firms – that had previously had little to do with a field they viewed as an area of expertise for notaries– and greater precision in the drawing up of contracts, etc.
It was not until the introduction of OPCI real estate investment funds in 2007 that the next decisive step forward was taken in France. Keen to develop third-party management in the real estate sector, legislators created a regulated investment vehicle that would be managed exclusively by management companies approved by the French market regulator AMF, which requires professional management and formalised risk management procedures.
Even if the insurance companies, REITs and listed real estate companies had already begun laying the groundwork for professional management practices, taking the initiative to adopt appropriate governance bodies and procedures, it was this latest phase that had the radical effect expected on standardising and mainstreaming best practices in our sector.
The twelve years that elapsed between the two events may be some cause for regret, but this should not overshadow the extent and depth of the work achieved. The result might also be criticised as lacking in pragmatism, since the product proved complex and costly to implement from the outset. Nevertheless, the adoption of a common code of practice now constitutes the foundation on which our profession rests.
The paradoxes of risk classification
The traditional view of the real estate investor, locked into the classic triad of decision-making criteria – “location, location, location” – that outweighed any sort of risk analysis has now been replaced by a somewhat infinite exploration of all possible risks; a list constantly being added to by lawyers.
The investor’s responsibility is to rank risk according to pertinence. While the exploration of areas of risk is now a familiar exercise, there is still progress to be made in this field. The single- strategy approach focusing on the “Paris premium”, for example, is now provoking the kind of price inflation in this asset category that itself constitutes a major risk.
In any event, the segmentation adopted by the global market reflects a desire to rank risks, as the following table illustrates:
|Little or no leverage
Liquid assets with predictable cash flows
Buildings and cash flows requiring enhancement
Buildings to be developed and cash flow to be generated
Certain paradoxes are still apparent in this classification: The market will accept adding risk upon risk, applying leverage to the point where the probability of seeing it transformed into a sledgehammer effect is at its highest, or operating on a short-term horizon even as development projects run over longer and longer periods, etc.
The importance of general risks
The first area to address is general risk, in particular market risk, the risk associated with the use of leverage and management risk.
Market risk can only be covered by judicious asset allocation and sound diversification. We will not dwell on the risks inherent in a cyclical market, since there is plenty of literature available on the subject.
No short-term investor, to our knowledge, can claim to have addressed these risks on any lasting basis. The only strategies that have proven effective are those based on investment horizons coinciding with what we know about the length of real estate cycles.
It is equally possible nowadays to identify certain harmful effects arising from the spread of mark-to-market accounting practices in long-term management strategies.
While not disputing their original intention, it has become clear that these accounting practices can sometimes cause short-term problems that managers have to deal with as emergencies, sometimes to the detriment of their shareholders or employees, and despite their potentially temporary nature.
The dangers of debt
One might imagine that the crisis of the 1990s had left the market with a permanent aversion to excessive use of leverage. Nothing of the sort.
When, as is currently the case, prices are rising and real estate yields are being squeezed, recourse to debt is a perilous exercise. Whereas in the past the banks rarely enforced their guarantees and allowed borrowers time, they are much less forbearing today and much better equipped. In the event of default, they no longer hesitate to step in.
To complete this picture, the French real estate financing market relies on short rates combined with hedging instruments. This adds a second category of risk, not forgetting the inflexible nature of covenants and the related costs of financing – time spent, lawyers, notaries, experts – all of which have continued to rise. Despite the attractive level of base interest rates, leverage is more than ever a tool to be used with caution.
Finally, regardless of whether portfolios are managed internally or delegated to external asset managers, risk management should also be taken into account.
Thought it is usually assessed through delegated management (via investment funds or listed real estate companies), managing risk internally may be underestimated.
In this sphere, there is often a tendency to focus on fault, error or even fraud, but the risk of losing precious resources in the form of experienced people should not be overlooked.
Once again, the precautionary principle would argue in favour of diversification. Some French investors now opted for direct investment domestically and indirect investment internationally, basing their decision on the sole criterion of expertise. Other institutions have opted for full delegation in order to avoid exposure to internal risks. Whatever the option chosen, risk management is best dealt with by relying on several teams, with complementary areas of expertise and profiles.
Clearly identifying specific risks
The risks specific to real estate assets are now increasingly well known. Among them are low liquidity, rental risk, credit risk on tenants, risk of obsolescence, environmental risk, pollution and latent defect risk, uncertainty as to costs and payback periods, tax risk, regulatory risk, fire or civil disorder risk (generally covered by insurance), and risk of natural disaster, etc.
Regulations now require vendors to produce an array of technical surveys when disposing of assets: inspections to detect the presence of asbestos, lead, wood-boring insects, etc. Buyers are also becoming increasingly demanding, requiring detailed records of the administrative history, surveys of the building condition and technical equipment, and carrying out in-depth investigations of a building’s tax status and rental situation.
These practices have something of a negative impact on liquidity, adding considerably to the preparatory work preceding a sale and turning notaries and owners into investigators trying to track down all the necessary papers to provide full documentation. Keeping that documentation up to date requires a great deal of work, and the market is in the process of counting the cost of this necessary form of risk management.
In a bull market, moreover, this virtuous transparency shifts the risk once carried by the seller onto the buyer. Transactions are conducted on the basis of data room audits so comprehensive as to allow sellers to proceed with sales on a no-warranty basis, for the very reason that they have provided full disclosure in advance and the buyer has had every opportunity to form an opinion and reach an informed decision. This was undoubtedly never the intention of investors at the onset, but it shows how managing one risk can cause another to appear elsewhere.
There are also the risks involved in the management of real estate transactions:
• Counterparty risk is largely covered by the application of anti-money laundering rules and the oversight provided by notaries. On volatile markets, however, the quality of execution of a transaction provides the buyer with an intangible value that must not be overlooked.
• The risks involved in selecting service providers is increasingly well covered by details delegated in contracts, but even so, checking the costs and services provided by subcontractors can reveal unpleasant surprises. Strict monitoring is required, further adding to management costs.
• Lastly, there is the risk associated with reinvestment, when sales are motivated by the purpose of realising capital gains, leaving unanswered the question of how best to reallocate the resulting profits.
The virtues of simplicity….
In conclusion, as we make progress in understanding and preventing risk, new risks emerge, not only as a result of regulation and the environment but also sometimes due to the unforeseen effects of procedures put in place.
In an increasingly complex world (governed by standards, technology, computerisation, organised by the processes of specialised teams), it is becoming very difficult for managers to maintain a strategic overview of risk. This is precisely where the major risk resides, and why we believe there is much to be said for simplicity.
In effect, certain technical specialists can pre-empt an entire sector of an organisation despite being disconnected from its vital characteristics and, above all, without having to assume the ultimate responsibility for any failings.
The occurrence of risk always affects an organisation from its roots all the way to the top. Whatever the delegations of authority in place, business leaders often find themselves left carrying the consequences alone, as well as having their image tarnished by actions that they had never intended.
The option of simplicity, visibility and transparency, coupled with a healthy mistrust of so-called technical barriers, is an excellent principle to adopt for anyone who wants sustainable control in the long run.
… and cooperation
Similarly, in an increasingly troubled economy, those who base their approach on cooperation and sustainable relations will, in our opinion, benefit from powerful qualitative levers to help them withstand market fluctuations.
The insurance companies that choose to swap assets rather than sell them, thereby avoiding exposure to the risk of subsequent reinvestment provide an interesting illustration.
Furthermore, cooperation with OPCI management companies makes it possible to use regulated vehicles managed by third-party teams, an option that offers numerous advantages in terms of liquidity and risk pooling, and even in terms of strategic partnerships.
In an unstable economic environment that puts a premium on increasingly scarce real real assets, such cooperation will be pertinent as regards not only to risk, but also performance.
We feel certain that a simple and clear common vision will offer the soundest approach with which to weather the economic crisis.