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IPE special report May 2018

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Sophisticated risk model provides dynamic insights

Much has been made of the controversial property markets and the risk they carry, says Pensioenfonds Metaal en Techniek (PMT). The €28bn Dutch metal industry scheme explains how various historical return records are available for property that is quoted on stock exchanges and this can be used to estimate risk. For unquoted real estate however, only limited data is available. Historical trends can be mapped for both Europe and the US, but questions remain whether or not these are sufficient indicators of investment risk. In addition, there is almost no data available for Asia.
Enough to deter most investors, but not PMT. "As a worldwide investor in both quoted and unquoted property, we are keen to gain insight into the risks unlisted property funds carry," the scheme says. "Therefore, our asset manager, MN Services, has developed a proprietary risk/return model for that purpose," it adds.
The risk model specifically seeks to measure the risk versus target returns for unquoted real estate and it will be used across the board in all the regions the scheme invests in. In designing the model, PMT and MN Services took the opportunity to bring some fresh ideas to the way property investment risks are traditionally managed. "The risks associated with investing in real estate are well documented and we have used this for the basis of our new model," says PMT. "But we have made changes."

The conventional model, which was designed by Chen and Hobbs in 2003, show the risks in a simple and objective manner based on country, structural and cyclical risks. But although these are considerations for PMT and MN Services, they were also interested in the risks the property fund itself incurred to get a fuller picture of the overall risks involved. There are existing fund level classifications: ‘core' is considered low-risk, low-return; ‘core plus' refers to medium risk and return; and ‘opportunistic' covers high risk but high return. But PMT feels these three categories are too broad for its objectives, and so it devised a more specific approach that includes other aspects such as leverage, project development and management track records.
"In order to arrive at a single risk figure, the various risk variables are quantified according to a pre-determined scale," PMT says. "The underlying main risk groups are therefore: country risk; structural property risk; cyclical property risk, and specific fund risk. The calculated score is plotted on a graph against the anticipated return of the fund," it continues.
The structural risks do not apply to shaky building foundations. They refer to the size of a given property market, its level of liquidity, transparency, the taxes the scheme faces and the extent of the scheme's property network in that country.
The cyclical risks are determined by the volatility of the property markets, sector-specific characteristics, the extent to which the property fund is geared to generate a regular income and the spread of properties over various market sectors.
The fund-level risks are caused by management risk, including how experienced the managers are; corporate governance; capital structure risk, such as maximum leverage and fixed or variable interest rates on loans; project development risk, which covers the extent to which development of the property is allowed, and currency risk.

PMT says in conjunction with MN Services, it uses this new model for every decision it makes whether buying or selling. This means the impact of any decision can be measured on the portfolio as a whole. The framework also allows for changes in the risk profile of the funds themselves. PMT claims this not only gives the fund a snapshot of the risk/return at the point a trade is made, but allows a dynamic insight into the risk profile of the overall unlisted property funds portfolio.
"What is unique about this model is that the country and property risks are quantified while the opinions of the portfolio manager about specific risks are also taken into consideration," the scheme boasts.
While PMT acknowledges its model may not give it the perfect insight into its real estate fund risk, it is more than satisfied that it has developed a means to adequately evaluate its property investments, allowing it to take decisions concerning property in the context of its overall investment portfolios and to monitor the portfolio's risk profile consistently.

Highlights and achievements
PMT's revamped risk measurement model for its property investments takes it to another level. Not satisfied with low-, medium- and high-risk categories, it has redefined the way its investments can be categorised and this has helped it determine the best means of generating excess returns from property.
Working in partnership with its investment manager gives it first-hand experience of how the market works and eliminates the to-and-froing it might otherwise experience by relying on advisers.
Keeping a tight rein on the property portfolios and using tactical asset allocation ensures it makes the best use of the funds and minimises their impact on its overall investments.

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