Risk Mitigation in Real Estate Portfolios

A comet, when first observed, appears as a fuzzy object to the eye. But as it approaches the sun, its appearance becomes clearer. Similarly, real estate investors had a fuzzy sense that something was amiss during the period from 2005 to 2007. Few, however, were able to dial back on the risk embedded in their real estate portfolio before the real estate comet became crystal clear and crashed into the market.

Commercial real estate has recovered strongly from the great financial crisis, but recent history compels us to be prepared for the inevitable vagaries of the market. There are no “bulletproof” deals, but portfolios can be monitored and managed for risk. Investors can try to insulate themselves from “known unknowns,” at least to a certain degree.

First, key risks can be monitored, including: real estate exposure; vintage year exposure; property sector exposure; leverage; and other exogenous variables. Real estate is inherently cyclical, as witnessed by the three property downturns over the past 20 years. Given that cyclicality, cost basis is a critical variable, driving performance. In real estate, cost basis is a function of vintage year. To address vintage year risk, investors have turned to pacing strategies and models designed to set the rate for deploying capital.

Investors should also monitor property sector exposure. The key elements of property sector exposure include: property type; geography; risk classification; life cycle of the asset; investment structure; and manager. Investors should look at their overall exposure to each of these components, on both a gross and net basis.

Another risk variable is leverage, which has come to be a dirty word in the wake of the global financial crisis. Fortunately there are a number of metrics for monitoring leverage risk. The loan-to-value (LTV) ratio is the most widely used metric. However, since LTV tends to decline when values are rising, pairing LTV together with the loan-to-cost (LTC) ratio is one way to mitigate the risk of adding to leverage when values rise. Neither LTV nor LTC capture the impact of leverage on returns or cash flow. For that, the debt service coverage ratio and net operating income metrics can help ensure that a property is not overleveraged. It is best that investors monitor the key risk elements at the aggregate portfolio level. While investment managers are tasked with optimizing transaction and performance at the deal and fund level, it is the role of investors to optimize at their portfolio level. Those two roles may not always be in perfect harmony.

But too often, organizations mistake risk measurement for risk management. Risk measurement seeks to quantify risk by way of metrics; risk management on the other hand is a function of processes and human judgment. Possessing risk metrics is not enough; judgment and thought must always be part of the equation.

Two pillars support a sound risk mitigation program: a well-devised investment policy and a rigorous and thorough monitoring system. The investment policy must reflect and communicate to managers the strategic focus and objectives of the real estate portfolio, yet be balanced by a built-in flexibility to position the portfolio for a fluid and changing market. An investment policy that can navigate between these two conflicting goals—strategic focus versus flexibility—can serve as a risk mitigation tool. However, the focus must always remain on the strategic objective of real estate in the overall portfolio. Otherwise, there is the potential for strategic drift and of introducing risks into the portfolio.

At the same time, monitoring systems and periodic reviews are essential for keeping the portfolio in line with strategic objectives. Paying attention to the “tall trees” and monitoring portfolio exposures can help ensure that an investor is adhering to the strategic objectives.

Finally, it is critical to keep in mind the people side of the equation. A successful risk management process must permeate throughout the firm and the decision-making process. Organizations must strive to have a balanced view from the investment/return perspective and the risk basis. It is important not to go into full-force offensive mode or retreat into a defensive posture for too long.

Of course, risk management tools will not prevent the next downturn, any more than a sharper telescope can avert Halley’s Comet on its next approach to earth in 2061. Instead, risk management tools enable investors to survey the market and to be more aware of the fuzzy objects that may be headed their way.