Risk is exposure to the consequences of uncertainty. It is the chance of something happening that will have an impact upon organisational objectives. It includes the possibility of loss or gain, or variation from a desired or planned outcome, as a consequence of the uncertainty associated with following a particular course of action.
What is Financial Risk?
Risk is exposure to the consequences of uncertainty. It is the chance of something happening that will have an impact upon organisational objectives. It includes the possibility of loss or gain, or variation from a desired or planned outcome, as a consequence of the uncertainty associated with following a particular course of action. Risk thus has two elements: likelihood or probability of something happening and the consequences or impacts if it does. Financial risk implies the possibility of financial loss.
Risks are often incurred in the pursuit of legitimate organisational goals. These include strategic, operational, financial and compliance objectives. Some risks must be taken in pursuit of business but organisations should be protected against those that are avoidable. The detailed justification and origins of financial risk management would require a separate paper on their own and are not within the scope of this article. It should for now suffice to say that in this current environment where margins are tight and organisations distressed, it will not hurt to protect the bird in hand.
This article makes a distinction between property held for owner use or for operational purposes and property held purely for investment purposes. The former is referred to as Corporate Property. The latter is Investment Property and its risk management is the focus of this article. There are three ways in which an investment generates positive returns. These are:
- generating a flow of income (or reducing income tax)
- generating a return on capital (or reducing capital tax),
- producing psychic income, a positive feeling induced by investment ownership.
The property Manager’s responsibility
A property manager seeks to increase return on a property and increase its value (capital). As discussed, risks arise in the ordinary course of meeting organisational objectives. Return is a function of risk. Modern portfolio theory contributes to this by regarding the investment decision as a trade-off between expected returns and risk. The simple conclusion is that risk increases required yield. This brings us to the Value Equation:
Property Market Value = (Rent less Operating costs) X (100/yield)
The thrust of a Property Manager is to manage the above value equation .The Market Value Capital) can be increased either by increasing rent or reducing operating costs (income) or increasing the last part of the equation through a reduction in yields (although it is debatable how this last strategy is with human endeavour. Risk Management can be used to achieve these strategies and to protect value accumulated.
The Risks Types in Property Management
Large organisations frequently hold property, for regulatory or prudential management requirements, for occupation or as a form of investment. The Capital values of real estate investments often account for a significant portion of the total assets for Zimbabwean companies. A problem exists for property owning companies in Zimbabwe in that there seems to be no formalised methods or frameworks for management of the different types of risk inherent in real estates. This means that a high percentage of their total assets’ values could be exposed to risks that are not being identified, measured, monitored and let alone controlled.
Board members for organisations active in the property market need to have reports on risk exposures at their disposal as part of good governance. It is prudent that they be confident management are in a position to identify, measure and monitor all risks. They also have a responsibility of ensuring that strategies are put in place to manage or eliminate identified exposures.
Generally, the following risks occur at Property Management level:
Investment quality risk factors
Investment quality risk arises from the changing nature of work, which alters demand for business space. Consequently changes arise in the aggregate level of demand and the location of that demand, the physical nature of the space required and the type of occupation desired. This risk manifests itself through the following:
- falling net rent
- unexpected repair costs
- capitalisation rates rises
- lower expected income growth
This is the risk that actual values may turn out to be lower than reported values. This risk can be depicted by an analysis of two hypothetical scenarios. The first relates to the portfolio value when the market is dynamic and abundant with transaction evidence. In valuing the properties in a portfolio, the valuer can be confident of the value figure to a high degree. The second scenario is when the portfolio is valued when the market is flat with sparse information. In this situation there is a high risk of mispricing the portfolio. Valuers should be required to indicate this risk in valuation reports for purposes of risk management.
This risk in Zimbabwe has been evident from the large variances in fair value adjustments by property owning companies in their end of year financial reports.
Illiquidity reduces the investors’ ability to switch between assets. It restricts the investor’s ability to restructure the portfolio in response to changing perceptions of sectoral and geographic performance.
Derivatives have been used to manage this risk. Derivatives are contracts whose value derives from the value of underlying assets. They provide a method of managing risk and uncertainty in the investment process. Derivatives in Real Estate attempt to address liquidity limitations in property due to large lot size, high transaction costs, thin markets, lack of a central market place and delay of legal procedures. The instruments available for adaptations to the property market are Future Contracts, Options and Swaps.
Swaps will be briefly discussed here as an example. A Swap is a contract between two parties to exchange cash flows for a specified period of time and normally involves either interest rates or currencies. Basically two parties enter an agreement in which one agrees to pay the other’s liabilities although a number of alternatives are available e.g. given an institution has cash assets that it wishes to invest in property it agrees a deal with an investment bank where the bank pays the institution the returns on a property index in return for a market index such as the London Inter Bank Offer Rate (LIBOR) in the UK. Alternatively an investor who wishes to disinvest in the property market and increase its exposure to the equities market could simply arrange a swap with an investment bank whereby the investor pays a return from an agreed property index and receives in exchange the returns on the equities market plus or minus a spread.
Liquidity risk is however more of an asset selection risk than portfolio management risk. Furthermore derivatives in any form are not available on Zimbabwean markets as yet partly because of legal constraints.
Covenant Strength risk
This refers to the ability of the tenant to meet the terms of the lease. It is anticipated that covenant strength information can be obtained from rating agencies such as Dun and Bradstreet (for a fee of course). Tenants may fail to perform repair and insuring obligations. They may cause physical damage to the property or stigmatise it (therefore causing financial loses or obligations to and for the owner. In some literature, this is discussed as tenant risk.
In Zimbabwe this risk was never more typified than in the wake of the December 2003 monetary policy. Many financial institutions, most of whom had occupied prime space in town went bankrupt overnight following the implementation of the policy. Consequently they could not pay their rents and service charges for office space.
Depreciation and Obsolescence Risk
Depreciation is linked to the passage of time, wear and tear and the impact of environmental factors.
Obsolescence is the decline in utility not directly linked to usage or environmental factors. For example it could be from the changing nature of organisational space requirements. As organisations seek to adapt to new competitive challenges, management have sought to respond to the environment through processes such as downsizing, delayering, outsourcing, and business process reengineering and core business focus. Downsizing and delayering in particular have led to a decline in demand for space. Business Process Reengineering and the focus on core business have led to demand for different types of space in different areas.
Location risk and Building risk
It is said in property the three most important factors are ‘location location and location’. If property is in prime location, it is always easier to find another tenant in the event of default by the existing tenant.
Like location risk, building risk is also concerned with how a unit might resell or re-let in the future. A well-designed and specified unit should be more attractive to tenants. For retailers, a quick example is given by the shops near the various bus termini. They experienced high turnovers because of high foot traffic. The downside is as close to home as the municipality’s decision to relocate the termini.
Legislation and Taxation Risk
This risk takes several forms. Changes in legislation such as the imposition of VAT on rents. Where a tenant is not VAT registered and is unable to recover the tax, it could affect their ability to pay rent and therefore the capital values. In Zimbabwe, the Regulations of 1982 and 1983 and of 2007 are an example.
This is different from legislation risk. It is the chance that title to an investment is not satisfactory. It is the risk that a better right might exist. It is the risk that a rent review is missed
Organisations should collect loss experience information from the above risks going forward. They should develop a generic approach to risk management that includes risk identification, measurement, and reporting and risk control. It is also important that this approach be communicated to internal staff, tenants and to external service providers. It is should however be noted that the scope of risk management in Real Estate goes beyond Property Management. It also covers portfolio selection and for investors, who have mixed investment types, includes risks that occur at Asset selection. These also need to be managed. Acknowledgements: D Mutemachani, First Mutual Properties – Extract from dissertation ‘Financial Risk Management in Property Management: A Case of Listed Companies and Pension Funds in Zimbabwe. 2006