Recalibrating risk

The business conditions created by the pandemic are giving way to a raft of new scenarios involving war in Europe, rising inflation, higher interest rates and continuing supply chain woes. How real estate investors are positioning themselves against the backdrop of the changed risk landscape. By Isobel Lee

Many investors remember clearly where they were when war broke out in Ukraine earlier this year on 24 February. In discussions about the business climate, there was almost an abrupt turning of the page: one day, all talk was of Covid-19; the next, attention turned to the ramifications of the first invasion of a sovereign state in Europe for 80 years. Although the effects of the pandemic clearly did not subside overnight, the impact of Russia’s invasion has both compounded the Covid hangover and created new pressures, slowing already weakened supply chains and labour flows still further. Now, most agree that recovery hopes for the sluggish global economy have been significantly set back. Says World Bank president David Malpass: “The war in Ukraine, lockdowns in China, supply-chain disruptions and the risk of stagflation are hammering growth. For many countries, recession will be hard to avoid.” He adds: “Changes in fiscal, monetary, climate and debt policy are needed to counter capital misallocation and inequality.”

Risk and opportunity management are two sides of the same coin

Across the real estate industry, a fresh consensus is building that vigilant risk management is required in these turbulent times. Notes Stephanie McMahon, Head of Strategy at BNP Paribas Real Estate UK: “There is an astounding number of big and small picture shifts that continue to impact real estate; from the global economic environment and how that influences capital flows, to the decisions that we are all making about how we want to live post-Covid-19. “When you add in longer term imperatives around the part real estate has to play in decarbonising and increasing biodiversity, the need to stay agile and innovative is fundamental.”

The focus of our strategy for the coming three years will be driven by three strategic pillars: growth, technology and sustainability.
Stephanie McMahon Head of Strategy at BNP Paribas Real Estate UK

Martin J. Brühl, Chief Investment Officer of Union Investment Real Estate GmbH, agrees: “The risk landscape has changed since the pandemic lockdowns, with the potential for recession and energy shortages added to the picture.” However, he underlines that risk vigilance is not just for downturns, but is an inherent part of an asset manager and investment manager’s role. 

“As a fiduciary asset manager, we are entrusted by our investors to take calculated risks in the real estate capital market in order to exploit the opportunities that exist there,” he notes. “In this respect, risk strategy is at the same time opportunity strategy, which manifests itself among other things in a transaction strategy, an asset management strategy and a liquidity management strategy.”

Investment risk management requires great vigilance

Zuhaib Butt, Director of Investment Risk Strategy Management, LaSalle Investment Management, takes a similar view: “Investment risk management has always been an integral part of managing real estate at LaSalle and we adopt a multifactor approach to managing risks as they evolve. 

“Our philosophy is that risk management is about risk optimisation, not risk minimisation. The key is to ensure we balance the risks we take with the returns we are generating for our clients, and not concentrating our exposures in certain types of risks.”

However, he acknowledges that the current macroeconomic landscape clearly calls for a particular kind of vigilance. “Macro and geopolitical factors are typically referred to as systematic risks due to the indiscriminate manner in which they impact underlying market conditions. Some of these risks can be diversified if global investment is an option, but finance theory suggests it’s impossible to mitigate them completely.”

Conditions are very different to 2008

ECB Banking Supervision, the European Central Bank body that is tasked with ensuring the safety and soundness of the European banking system, has already identified banks’ exposures to the commercial real estate (CRE) and residential sectors as a key vulnerability in its risk assessment for 2022–24.
While CRE is considered vulnerable in the short-term, medium-term risks of price corrections continue to grow in the residential segment, with signs of a potential overvaluation in housing prices and elevated household indebtedness.

ECB Banking Supervision data shows that banks’ exposures to the CRE sector are substantial, accounting for around 8 percent of supervised banks’ total loans and over 20 percent of their total corporate loans. In absolute values, CRE exposures are particularly high in Germany, France and Italy. In other countries, such as Cyprus, Slovenia and Estonia, their relative size is material, with CRE exposures accounting for over 40 percent of total corporate loans.

New regulations like Basel III meant that it became prohibitively expensive for banks to lend on speculative projects.
Mark Callender Head of Real Estate Research, Schroders Capital

Long memories of the damage caused by the global financial crisis (GFC) nearly 15 years ago have increased institutional vigilance across the board. However, Mark Callender, Head of Real Estate Research at Schroders Capital, underlines that key conditions have changed significantly compared to 2008. “Historically, real estate capital values were quite sensitive to changes in short-term interest rates, because both developers and investors were highly geared. However, that changed after the GFC,” he notes. 

Union Investment acquired Degerloch Office Center 1 and 2 on the southern fringe of Stuttgart city centre via a forward funding deal. Completion is scheduled for the fourth quarter of 2023. The two properties are expected to receive DGNB Gold certification.
Union Investment/WWA Architekten Wöhr Heugenhauser Johansen Part mbB (simulation)
Our philosophy is that risk management is about risk optimisation, not risk minimisation.
Zuhaib Butt Director of Investment Risk Strategy Management, LaSalle Investment Management

“New regulations like Basel III meant that it became prohibitively expensive for banks to lend on speculative projects. In addition, investors learnt that debt is a double-edged sword, amplifying a fall in capital values.“Where real estate investment trusts (REITs) typically had loan-to-value ratios of 60–70 percent before the GFC, they are now generally between 20–30 percent. Furthermore, fixed rate loans have become the norm over the last five years, so most REITs should initially be insulated from rises in interest rates.”

Today’s institutional investment managers are seeking to apply a range of strategies to mitigate risk.Says Butt: “We believe that managing risk requires a combination of a top-down and bottom-up approach. Data is the cornerstone to any risk process worth its salt, but it still needs to be balanced with interpretation and experience. Oversight from our Investment Risk function helps to ensure we balance the risk/return characteristics of the market and properties held on behalf of our clients.” Butt notes that LaSalle’s research & strategy team plays a key role in all this, underlining that useful data points can come from a wide range of sources – “whether it be high-frequency equity data or web scrapings from social media or other non-traditional data sources.”

Stricter selection of markets, assets and transaction partners

Brühl says that Union Investment’s asset management strategy focuses on “value enhancement, or at least long-term value preservation as a goal” in the current environment. Tools include extended fixed-lease terms where possible for longer-term retention of quality tenants and minimising tenant churn, allied with “manage to green” approaches to make assets greener and avoid “brown discounts”.

The company’s investment management strategy, on the other hand, is characterised by a stricter than ever selection of markets, assets and transaction partners. “The time of cheap debt and chancers is over,” Brühl says. “It’s the hour of the equity-strong investor, so we are seeking to invest only with a sense of proportion and conviction in the meantime. “Our time will come. The interest rate turnaround will eventually lead to distressed sales, but some of the current issues will also level out.”

For BNPPRE’s McMahon, innovation is essential to make progress: “In order to mitigate risk, drive organic growth, develop new opportunities and generate economies of scale, the focus of our strategy for the coming three years will be driven by three strategic pillars: growth, technology and sustainability. “Talent will be key. Since the beginning of the year, we have recruited 144 new people, including 15 senior leaders across the breadth of the business.” The firm will also continue to build on its partnership with proptech venture capital firm Fifth Wall, which has been giving BNPPRE access to tech solutions to help it make tracks in terms of digital transformation, while “financial acumen” will remain a “priority”. 

Income growth forecasts increasingly uncertain in the property world

“BNPPRE is the only UK real estate adviser to be part of a banking group. This financial fluency means that our ability to provide not just property expertise but also financial solutions and insight is unrivalled,” she says. Despite robust attempts to hedge for risk, complications may yet emerge in the current climate. Europe-wide sanctions against Russia mean that the real estate world has been forced to be increasingly aligned with the securities industry, for example, which has typically taken a much more forensic approach towards its capital sources, in its ongoing battle against money laundering and terrorist financing. The property world is also facing cracks in income growth forecasts due to the relationship between bond and real estate yields. Suggests Mark Callender, Head of Real Estate Research at Schroders Capital: “Bond yields may start to put upward pressure on real estate yields. If that does happen, in general we expect that those sectors with the strongest demand and supply fundamentals and best rental growth prospects will be less affected.

“For example, we would expect multi-let industrials, prime offices and retail parks to be less affected than shopping centres and secondary offices.”Callender adds that the minority of investors who have managed to secure index-linked leases are best protected against higher inflation, but he points out that “capital values will still be influenced by wider movements in bond yields and real estate yields.” He notes: “There is also a danger in sectors with weak demand and supply fundamentals that rents will drop to open market levels, once current leases expire.”

While real estate investors might be tempted to hit pause on increasingly expensive refurbishments in the current climate, experts in ESG urge landlords to maintain a long-term view that is nevertheless sincere, in the light of recent greenwashing scandals in the industry.

ESG calls for brave, long-term management approaches

Tom Scott, co-founder of carbon verification specialists Construction Carbon, acknowledges that “the supply chain issue is really pressing” but sees an opportunity for the real estate industry to be braver than ever. “Let’s address the entire construction industry. Let’s look at new materials and recycling on a major scale. We are long overdue a second industrial revolution to create a whole plethora of new types of building materials and methodologies.” Natali Cooper, Managing Director, Head of Portfolio & Asset Management & ESG – Europe at logistics specialists GLP, agrees that “resource scarcity” may be here to stay and should thus be embedded in long-term strategies. “Reducing embodied carbon in construction is also about efficiency. By adopting a forensic approach, we are often able to cut out excess materials from the scope, thereby saving carbon but also money and resources, which will be increasingly key.”

Nevertheless, despite the diverse threats in the current risk landscape, the smartest real estate investment managers are on the whole positive that they have the right tools to navigate the next 12–18 months. Says Callender: “We do not expect to see a big increase in distressed sales over the next 12 months, although some private property companies and foreign investors with high levels of gearing could come unstuck.” He concludes: “At the end of the day, real estate is a chameleon asset class. It sits somewhere between fixed income and equities, depending on whether rents are rising or falling.”

By Isobell Lee

Title image: Bertram Kober/PUNCTUM

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