Listening to the investors
IPE Real Estate spoke to four major European real estate investors about their views on risk management in real estate portfolios
The questions we asked
n How do you measure risk?
n Do you perceive risk to be “volatility” or do you focus on downside risk only?
n Is tracking error an important metric?
n Do you have a specific way to manage risk in a real estate portfolio?
n How does your approach to managing risk differ between direct investment and investments in vehicles, both listed and unlisted?
n Does your approach to managing risk differ where you have a reliable direct property benchmark?
n When investing internationally, how much emphasis do you put on levels of cross correlation? Do you do this at a country level or at both country and sector level?
n Are benchmarks any use?
n Should absolute risk measures be used for absolute return funds?
n Should risk management reflect risk adversity?
n How aligned are manager risk and investor risk in unlisted vehicles?
n Do you use or are you familiar with the Blundell Risk Web, which plots a portfolio’s exposure to a number of real estate risk factors, such as tenant concentration or development risk?
The Church Commissioners
The Church of England is one of the largest owners of real estate in the UK. The Church Commissioners, which manages the Church’s assets, controls £4.3bn (e6.3bn) of total assets, £1.3bn in real estate, most of which is directly owned and in the UK. However it has stakes in a number of UK limited partnerships and has recently committed to investing in ING’s Central Europe fund.
The Church has a number of investments which have come as a consequence of it holding significant amounts of land. For example, it owns 10% of the MetroCentre in Gateshead, one of the largest shopping centres in the UK.
It owns around £300m of UK residential and £650m of commercial real estate, with the rest of the portfolio being the rural estate. As a consequence of its long establishment and the building of real estate portfolio a long time before modern portfolio theory came into being, the Church is faced with different problems to a pension fund building up a new real estate portfolio.
Investment analyst Chris West says the Church measures risk as standard deviation of returns, with reference to the IPD UK index, which it aims to outperform. Through IPD the Church uses the Blundell Risk Web to analyse how factors such as tenant and location concentration, development risk and sector balance affect the portfolio.
West says: “We are trying to balance the portfolio and bring weightings more in line with the IPD average. For example we are looking at selling some of our residential holdings, where we have been blessed with strong returns in recent years. We are overweight in high street shops, and are looking to move some of that weighting into retail warehouses for example.”
Many investors make their first investment outside their home market in order to reap the diversification benefits. However, the Church’s investment in the ING Central Europe fund has been made in order to take advantage of the higher income returns available from that vehicle. “This is basically a satellite approach, something outside our main portfolio which can offer added returns,” says West.
When looking at prospective investments the Church looks at the potential risks as well as the potential returns. “We look at the risks that might exist: we look at rental growth expectations for the next five years and then look at how volatile those rents might be. We also look at anticipated void periods and refurbishment costs,” says West.
West has recently introduced Monte Carlo modeling to the Church’s real estate division. Monte Carlo simulations randomly generate values for uncertain variables over and over to simulate a model.
“So for example we may say that we think refurbishment costs are going to be , say, £20/ft2certainly no less and maybe significantly more,” he says. “We can then skew the model and do a Monte Carlo simulation in order to look at the most likely NPV and also the chance we have of achieving our required return.
Looking at investments and the whole portfolio, the Church factors in both the total volatility and the downside risk, says West. The Church is also taking a very long term view to its portfolio. “You don’t get much more of a long term investor than the Church commissioners, it’s very much a long term player!”
The Church’s investments in limited partnerships are made in order to gain access to markets where the Commissioners do not have experience says West. “Managing risk in these investments is different,” says West. “But appraising the underlying assets is a similar process.”
ABP, the Netherlands’ largest pension fund and one of the most sophisticated investors in real estate worldwide, takes a measured approach to managing risk in its real estate portfolio. The portfolio differs from that of many investors in that ABP no longer owns direct property – having investments in both listed and unlisted funds.
In the early 1990s the fund moved out of direct investment for organisational reasons and created wholly owned funds for its residential portfolio (Vesteda) its office portfolio (KFN) and its retail portfolio (WFN, later merged with the listed fund VIB into listed fund Corio). ABP was keen to separate the roles of operator and investor – which allowed its in-house team to dispassionately focus on areas such as risk management.
Portfolio manager Rob Bingen says: “Risk management is an integral part of investment and portfolio management process of ABP Investments. Every investment or disinvestment decision is an evaluation of the appropriate return-risk profile, related to the specific asset category. This is not just limited to return volatility (or expected volatility), but also includes minimizing exposure to specific risks, such as legal and reputation risk.”
He says to understand the approach of ABP to risk management of real estate investments requires breaking the topic down into a distinction between listed and private indirect real estate investments as well as risk management of individual investments versus portfolio or fund risk management.
Listed real estate companies
ABP manages its listed portfolio in a manner consistent with the way equity portfolios would typically be managed. Its approach for its listed real estate investments works in the same way as its approach with other listed stocks. The pension fund’s main goal is outperforming a selected listed real estate benchmark - in this case the benchmark provided by the European Public Real Estate Association (EPRA). “This is achieved by superior stock, sector and country selection,” says Bingen. “Our main concern in terms of risk is more on a relative than on an absolute level (relative risk parameters vis-à-vis our benchmark).”
ABP therefore uses tracking errors to measure its active risk. This measures both individual stock risk and the correlation between each individual stock in an overall portfolio context. Given the output of ex-ante tracking errors and the corresponding attributable risk on a share-by-share basis, the fund managers optimise the portfolio’s risk return output.
“We will select those stocks, which give us the highest risk adjusted returns. On an absolute stock risk level we use a fundamental approach in which each company is classified in terms of sector risks,” says
ABP looks at the fundamental real estate risks inherent in a company’s portfolio. These include leasing risk, tenant risk and financial risk, all of which are taken into account in order to estimate the fundamental risks concerning each individual company
Private real estate funds
“Risk measurement in this asset class is more complex,” says Bingen. “Two important general considerations are the limited influence of investors once the investment or commitment is made and the limited liquidity of participations in private real estate investments.” Investors with the size and influence of ABP can have more influence than most once the investment or commitment is made, but that influence is still restricted, post-investment, to a seat on an advisory board.
“Risk management in private real estate vehicles starts at the investment selection and underwriting process,” says Bingen . “At this stage you can exercise influence.”
That influence is an important element in the investment process and therefore includes ensuring that risks are minimized at an early stage and before cash is committed. It is also useful that, additionally or alternatively, key controls established to ensure that sufficient influence can be exercised should certain risks surface in the future. Bingen says the various elements of attention include, but are not limited to, feasibility of the fund’s strategy, debt management, alignment of interest between management and investors and general corporate governance factors.
“After the investment is made risk management becomes a more integrated part of investment monitoring and performance analysis,” says Bingen. This performance analysis entails evaluating the actions by the manager over the period under review. ABP also undertakes a review of the manager’s achieved returns and comparing these with the original business plan and the returns targeted for that stage in the fund’s life. As usually there is no relevant benchmark available for unlisted funds, although INREV is working towards this with the launch of the first index for European unlisted vehicles, comparative analysis at this level is often difficult to perform.
However, where specific there is benchmark data available, for example at the property level (and this is not always widely or reliably available for all areas of Europe and further afield), this may be used by ABP to increase its understanding of the relative performance at a more detailed level. Following the internal analysis ABP will liaise with the manager to obtain more insights into the risks the investment is exposed to.
Portfolio risk management
ABP characterises its private
indirect real estate portfolio into three3 types of products; core, enhanced return (value-added) and opportunistic. This classification is based on a number of parameters. An overlay of historic and expected returns gives a good indication of the risk, characterised as the return volatility, of the portfolio.
“Additional slicing and dicing to sectors and markets provides us with additional insight into the level of diversification - risk mitigation,” says Bingen. “Also here an overlay of historic and expected returns provides a tool for risk management.
“However, we should be sensitive to the fact that most indirect real estate vehicles have cross-country or cross sector strategies and in some cases both. There is also a widespread lack of liquidity, which inevitably limits the extent of active portfolio repositioning.”
A third element of risk management involves identifying and monitoring certain key performance drivers. These include debt management factors, development content, and the exposure to certain markets or sectors. This analysis provides good insight into risk (ie changes) on an individual investment level but is also a risk measure on the portfolio level.
This process creates an overall score which can then be compared to the profile of the listed real estate market on these factors. Assuming a broadly diversified listed real estate market now becomes a proxy for assessing risk.
Bingen says that process is essentially a factor model and compares with LaSalle Investment Management’s Blundell Risk Web is easily made. However, the BRW typically identifies certain real estate factors, such as tenant, asset and location concentration, sector balance, lease lengths. The assumption is that diversification decreases risk.
He says: “ABP’s real estate investments, given its portfolio size and composition, are already very diversified. As such, whether an individual investment has a very narrowly defined strategy, or a broad one, is less relevant in an overall portfolio context. In that respect, it is more important to ensure exposure to multiple vehicles to diversify manager risk.”
Development of the risk management process for ABP is ongoing. Challenges going forward with the factor models include establishing appropriate benchmarks and relative importance of factors. “With more data on property and private real estate funds performance becoming available we are now increasingly able to benchmark our portfolio. But more work in this field needs to be done,” says Bingen.
ATP REAL ESTATE
Danish pension fund ATP’s real estate holdings are moving to a different risk profile as it diversifies overseas ATP is one of Europe’s largest pension funds with total assets of around e41bn. ATP’s current allocation target for real estate is 5% with a target split of 70/30 between Danish and European real estate.
The pension fund’s current European investment programme was launched in 2002 and aims at building up a portfolio of 15-17 unlisted real estate funds spread across Western and Central Europe.
So far ATP has committed around e370m to 12 real estate funds and is looking to complete the programme, investing e550m within 12-18 months.
Chief financial officer Allan Mikkelson says “When we start to talk about risk in real estate an ALM study has already been done to decide the allocation which involves risk consideration. Within the real estate portfolio we are looking at generating a risk-adjusted return and the risks involved in real estate are pretty simple really.”
For ATP the main word is ‘diversification’ when it comes to managing those risks. Examples Mikkelson cites include geographical risk – by country or regions within a country, by sector, by primary or secondary markets.
“That’s how you kick off your portfolio, you look at the inherent risks in real estate before you invest, which decides where you invest,” he says. However the process changes when ATP has made its commitment to an investment the risk monitoring changes as it are monitoring the product it invested into rather than the market. “With an unlisted fund for example you have to make sure the fund is performing in line with your expectations and within the boundaries set out before you invested,” he says.
“We tend to say this is not rocket size. It’s diversification and monitoring that process. We want an absolute return from our portfolio and then say ‘how do we get to that number?’”
ATP has investments in core, value-added and opportunistic investments. It has a model which monitors its investments on an ongoing basis. With the indirect market , ATP looks at the commitment made to each fund, factors in the investment style, sector spread and gearing. Using the model it can quantify how much more debt it can take on in a certain fund, whether it can invest in an opportunity fund or in a certain locale. New opportunities are added to the model to see if they fit in.
“So we have a gearing target of 60% but could invest in an 80% geared opportunity fund if our overall gearing remained below 60%,” says Mikkelson. However, if a potential investment does not fit in the model it cannot be made without a change to ATP’s strategy.
Looking at the group’s direct portfolio, Mikkelson says the direct investor is closer to the process. It’s also the area where benchmarks are available, although he points out that the IPD benchmark for Denmark and for the area around Copenhagen in particular is not that mature.
“That's why we often look at absolute returns. In some markets, if you use a benchmark the manager can outperform a weak benchmark but still not do so well. if he is outperforming a very low benchmark we as investors are not getting the return we were promised initially,” says Mikkelson..
ATP believes that to align manager and investor risk in unlisted vehicles, a significant co-investment is required to align manager and investor risk on both the upside and the downside.
Volatility is not a major worry for ATP. “We are very long term investors so volatility is not that important,” says Mikkelson. “Having said that we know that property has cycles and if you get your timing wrong then the volatility of the property market can go against you.
UK-based Grosvenor is one of the largest private property companies in the world. Wholly owned by the Duke of Westminster and his family, it has £4bn invested globally. More than half of this is in the UK, but Grosvenor has significant assets in continental Europe, North America and Asia.
Head of research Darren Rawcliffe says Grosvenor has “embraced” modern portfolio theory in recent years. “Classic portfolio theory has had a big impact on how we look at our overall portfolio.” We’re very concerned about overexposure to particular markets. Even if you are controlling the risk in individual assets very well the market risk is so large we spend a lot of time thinking about diversification over different
“If you stay focused in a single market, then when it goes down you suffer, however deep and diverse that market is. So you need to find something where there's less correlation - for example we find Euro-zone retail has a low correlation with all UK property.”
Looking at volatility, Rawcliffe notes “The reason volatility works as a measure of risk is that in most distributions the upside events are symmetrical to the downside events. So assets with the most volatility have the most downside events. Thus ranking assets by volatility is equivalent to ranking them by downside risk.”
He acknowledges that in real estate this is not always the case, citing an Investment Property Forum study which found that, at the portfolio level, risk cannot be simply described as volatility.
So while Grosvenor does often treat volatility as risk in some circumstances it needs to look at the downside risk. For larger projects, such as developments, the company uses a value at risk measure. Rawcliffe explains: “This takes the downside tale of events (the bad part of a normal distribution curve) and looks at the probability of making those losses.
“You can ask what probability do we have of losing a certain amount Alternatively you could say ‘for the worst 5% what’s the amount you lose?’ The problem with this is that it is a snapshot.” Grosvenor has been using simulation technology to assess overall distribution.
Rawcliffe says that hurdle rates are the basis for all Grosvenor’s risk perceptions. “We base everything on a risk-free rate. We quantify the risk contribution from the various risks you find in a real estate asset, such as rent volatility. Data varies so dramatically in our markets that we can't have a one size fits all technique. We have to be flexible to use the best technique in each market.”
Grosvenor has a cost of capital figure which is used to capture the risk to itself as a corporate vehicle. That cost of capital will take account of the variability of returns across the whole portfolio and also factors such as the amount of leverage the company has taken on. That cost of capital however doesn't translate directly to individual projects.
“Some people use overall cost of capital as the hurdle rate for individual projects, but we think that’s the wrong approach,” says Rawcliffe. “You must define a hurdle rate for each asset but also make sure that across all your assets you're meeting your cost of capital.”
Grosvenor still uses benchmarks and monitors tracking error where reliable benchmarks exist. “In a number of markets we're in there are no reliable benchmarks so there's no point in looking at tracking error,” says Rawcliffe. However he points out: “In those markets where there is a benchmark, say IPD UK we've tended to focus on outperforming the benchmark. But we are finding more and more people are not interested in seeing outperformance of the benchmark if that is outperforming -2% returns. So absolute returns become more important.”
Despite its large and widely spread portfolio, Grosvenor still focuses very heavily on managing the risk in individual assets. “Asset-specific risk is very important in real estate,” says Rawcliffe. “Firstly, two buildings right next door to each other can perform totally differently based on some idiosyncrasy but primarily because direct real estate is the only asset class where the investor can do something about the asset that has been purchased. For example if you buy a stake in BP you can't do anything about its risk profile, but you can do a lot about the risk profile of individual real estate assets.”