Commercial investors: risk management in the property market
Monitoring, managing and mitigating
11 September 2017
Gary McNamara explores how investors manage risks after a turbulent year for the property market, and details one common approach
Any investment means taking a risk. The key thing is how this can be monitored, managed and, where possible, mitigated.
The extent of risk taken is usually linked to a required or expected return. In multi-asset portfolios, where investments are placed in bonds, gilts, equities and property, the aim is to diversify risk and returns across all asset classes and optimise the portfolios’ performance through the cycle.
Although risk is always present, it changes over time. More emphasis has been put on risk management since the global financial crisis in 2008, though this changes depending where we are in the economic or political cycle. Notable changes have occurred in regulation with the Basel II standard for banks and the EU’s Solvency II Directive for insurers, which ensure that the respective professions hold a certain amount of regulatory capital against investments as a buffer.
Last year created uncertainty across the business world
The European Market Infrastructure Regulation has also ensured that all over-the-counter derivatives trades occur across an exchange through a central clearing counterparty, where they can be formally registered and cleared. This helps the regulator look through to any counterparty if required, and work out how much risk is being held.
Last year was full of risks. On the first working day of 2016, London found Asian stock markets in crisis as global concerns were building about China’s ability to grow and its fast-mounting levels of debt. Markets around the world were shaken, not least the UK property market.
In February, as the turmoil in global stock markets continued but showed signs of stabilising, the UK announced that it would be holding a referendum on EU membership. The 4-month notice period of a major political event caused investors to retreat further by putting deals on the back burner and deciding to wait and see what would happen. March then saw the rise in Stamp Duty Land Tax of 1%, which made it more expensive to buy commercial property.
Following the referendum result, many property fund managers were worried about capital values falling by as much as 15%, with some funds being forced into quick asset sales to meet their redemption requirements. The rest of the year in UK commercial property was not as bad as initially perceived, however.
An unprecedented and consequently unpredictable year, 2016 engendered uncertainty across the business world. It saw various risks related to different assets, with liquidity proving a challenge for some retail property funds.
Liquidity and volatility
The uncertainty and liquidity issues of 2016 were felt by several markets across all asset classes. This led to the mitigating international Financial Stability Board, a group of G20 leaders who meet to promote the reform of international financial regulation, issuing 14 policy recommendations in January 2017 to address structural vulnerability from asset management activities.
In February, the UK’s Financial Conduct Authority went on to publish a discussion paper entitled Illiquid assets and open-ended investment funds, with specific reference to property funds, to address liquidity risk. These 2 regulatory initiatives show an increasing emphasis on the liquidity risk experienced by funds.
In knowing that property funds experienced liquidity issues in 2016, the Association of Real Estate Funds (AREF) commissioned a report to examine how various funds managed their liquidity in the period of volatility. This was an early initiative that was seen as a proactive rather than reactive step by the commercial property market.
RICS also set up its Global Investment Risk Management Forum last year in an effort to gain a better understanding of, and address the challenges and opportunities in, effective risk management. The forum is led by RICS past president Martin J Brühl.
In property, many risks are associated with the nature of the asset class, including those relating to the tenant, location and sector; 2 others that have come to the fore in recent years are liquidity risk and market risk. What is important is the way that fund managers monitor, manage and mitigate these risks where possible.
In a class such as property, an investment strategy is used to ascertain where and what assets should be purchased. Are these assets being purchased for income returns or longer-term capital returns? Property provides a total return that comprises both – income in the form of rent paid and capital in terms of changing capital value. A fund manager will be aiming to increase these returns while also protecting them.
Many fund managers see a diversified portfolio as a means of risk management
Since 2008, diversification strategies in many UK institutions have changed. As an investor, would you prefer to own a portfolio of retail properties alone, or would you like one made up of assets diversified between office, retail and industrial premises? Many fund managers consider a diversified portfolio as a means of risk management, given the differing performance attributes of the various assets.
Historically, liquidity and market risks have been managed using more liquid forms of property, such as real-estate investment trusts. In other asset classes, various risk management tools such as futures, derivatives and options are used to help the managers of funds protect capital values and enhance portfolio returns throughout the market cycle.
A recent addition to the risk management toolbox for property fund managers is MSCI/IPD property futures contracts, which help manage liquidity and market risk alike. Two specific uses by fund managers are discussed below.
Liquidity risk management
MSCI/IPD property futures are a liquid form of exposure that can be traded daily on the regulated Eurex Exchange, where buyers and sellers can transfer property risk in compliance with regulation.
Due to the flexible and inexpensive nature of these futures, property funds with excessive cash holdings can use them either to reduce cash drag on their performance, or to help manage redemptions quickly.
Market risk management
Tactical asset allocation is used by fund managers to manage the portfolio weightings into certain sectors or geographical regions. To change these weightings in the past, fund managers have had to sell an asset and then buy another in a different sector or region. This has been time-intensive and also entails high transaction costs, which in turn erodes returns by around 8% for buying and then selling an asset.
Figure 1: Reweighting portfolios
A new method is now available to fund managers, however, whereby they can use property futures to reweight their portfolio to their required sector or region for a fixed period, until they review the strategy. Such reweighting strategies are used in all other asset classes, with property being the last main class to follow this route.
For example, assume the fund manager wants to downweight exposure to offices and upweight to industrial. They 'sell' the MSCI/IPD Office Index and simultaneously 'buy' the All-Industrial Index (see figure 1). This is done looking at the portfolio as a whole or overlay strategy for a specific period of time, without the need to sell any direct assets. In doing this, the fund manager has reweighted the portfolio to the desired sectors in a timely and cost-effective way.
Other strategies that have been used by fund managers in dealing with market risk exposure include buying the required index to gain exposure to a specific sector while they are waiting to find suitable assets. They can also sell the index to hedge or remove exposure to a specific sector. Figure 2 shows the property futures contracts that can be transacted on the Eurex Exchange.
Figure 2: MSCI/IPD property futures contracts transacted on the Eurex Exchange
Such overlay strategies are constantly being developed, leading to a range of new and innovative property risk management techniques.
Gary McNamara is Director at Arca PRM
- Related competencies include Investment management (including fund and portfolio management)
- This feature is taken from the RICS Property journal (July/Aug 2017)