Property Fund Management - to 2010 and Beyond
To 2010 & beyond – are your decision-making, systems and processes sufficiently robust and integrated to cater both now and in the future? Nick Percival takes a look at some of the pertinent issues in the first of a series of articles.
It is very tempting to think that because the unprecedented turmoil surrounding the financial markets appears to have stabilised somewhat, the property industry can return to its historically independent asset “cocoon” and carry on nearly as before. OK, loan to values will have to be lower, possibly for quite a while, but otherwise aren’t things pretty much OK now that asset values have returned to attractive levels, having fallen in many cases by around 50%? After all, most of us prefer the status quo and besides if it isn’t fundamentally broke then don’t fix it, especially if it’s going to cost......
Unfortunately, there are a few “flies in the ointment” which are likely to prevent this, both in terms of whether maintaining the status quo is indeed adequate (given the continued uncertainties) and whether it will be sufficient to at- tract future investors to your particular fund(s). As the first in a short series, this article seeks to identify the major issues and to describe the first three of these in a little more detail.
Are we through our Darkest Hour?
It is by no means certain that we have reached the bottom and that it is now only upwards from here. Property is very much a late cycle asset particularly in respect of upturns. So far there has been only relatively little debt maturing to date, (surprisingly) limited ten- ant defaults and therefore limited knock-on effect upon rents, with the lenders having barely started in clearing out their problem loans and CMBS/RMBS investments. It may be considerably too early to conclude that existing decision- making, processes and systems are adequate and sufficiently co- ordinated and sophisticated (let alone “best in breed”) to cater for either the present or investors’ future requirements.
Property Investors’ Confidence
This has taken a major battering – in recent times property was often increasingly sold as a virtual panacea i.e. a low risk, low volatility, high yield, high return and uncorrelated asset class. Recent months have almost universally disabused us of this rose-tinted view, particularly in the US & UK. As with many other asset class investors, property investors are, in future, going to be far more selective about who they are going to invest their money with. Property managers need to position themselves in terms of man- ager track record, systems and processes if they wish to access investors’ cash going forward.
This is a new tool now available to the property industry. Property Derivatives are being increasingly used by investors and managers alike whether for hedging or speculative purposes. Addition- ally, property derivatives pricing gave early warning of both property price falls and indeed their extent, making them a valuable predictive and decision-enabling tool. These instruments need to be appropriately monitored and valued (particularly with the now much greater awareness of counterparty risks). They also need to be integrated into decision-making and other processes and systems (including trading) not only within the property operations but also across other asset classes.
Interest Rate & Foreign Ex- change Hedging and Hedge Accounting
It remains surprising how many parties still do not adequately or accurately consider the impact of interest rate and foreign exchange hedging in changing a project’s risk profile, both at the time of entering into a transaction and on an ongoing basis. This is especially so when the project’s nature changes significantly (e.g. a letting) or there is a significant movement in interest rates or exchange rates. Recent events have again demonstrated the extent and speed at which rates can move, highlighting the de-risking potential of hedging, particularly by reducing the severity of bad outcome scenarios. Additionally, an increasing number and type of vehicles are required to undertake hedge accounting or have investors/managers who are subject to these accounting rules. To attract future investors to these vehicles, systems will need to be in place to provide these functions.
Increasing Desire to Integrate Property with other Asset Classes
Many multi-asset managers and investors’ believe that property has (again) become a mainstream asset class and should therefore be evaluated on a consistent basis with other such classes. Recent events have highlighted that there are potentially common exposures across classes (e.g. tenant/corporate credit risk) and counterparty risks (e.g. bank loan & hedging counterparty risks as well as bank corporate credit risk). The fall of Lehman Brothers and others has highlighted the need to have accurate and timely monitoring of both entity level and group- wide counterparty exposures. As a significant source of potential counterparty risk, property will have to become much more consistently treated and integrated with other asset classes systems- wise, to enable group-wide exposures to be assessed on a timely and accurate basis.
The Importance of Liquidity
Until recent events, this was left off many radars and the need for a prudent level of liquidity and timely systems to monitor such levels were not appropriately recognised. This appreciation has radically changed. A difficult lending environment (envisaged for some considerable time), continued economic and investor uncertainty and tougher investor requirements, will all ensure the new requirement for formal liquidity monitoring will remain. To be effective, such systems have to be capable of monitoring a wide range of variables on a timely basis, from possible debt covenant breaches (e.g. LTV, ICR & DSCR) and the ability to call capital commitments, through to margin calls on derivatives and loans as well as falling income from tenant defaults and possibly exchange rate movements.
Better Appreciation of Volatility, Leverage & Risk
Consideration of these concepts separately, let alone combining them, was largely ignored by investors and managers alike in the property bull run and has now come back to haunt. Many real estate equity investors (and managers with promote remuneration structures) viewed leverage simply as a way of enhancing (or achieving certain minimum) return levels rather than substantially increasing risk. Whilst it can be argued that the (long) rise in property values statistically reduced volatility (thereby reducing the modelled risk of poor outcomes), for those of us with longer memories, steep falls in property values have occurred more than once in our lifetime and this possibility should always have been included in any modelling and/or deal structuring. In most cases insufficient attention was given to modelling downside cases – often very limited downside cases or upside cases only were considered. And most investors almost certainly never modelled the possible variability of returns due to the under- lying asset volatility, the addition of leverage and the possible disconnect between interest rates and property yields. Whilst it is true that much of this modelling “error” can be categorised as poor and ill-informed decision-making by deal makers and their investment committees, going forward it is also going to be the case that investors are going to want to see decision-making properly codified with the modelling approach, assumptions and sensitivities much more transparent and vigorously tested. And of course utilisation made of property derivatives as a predictive & valuation tool in addition to reliance on agents’ forecasts....
I’d now like to expand a little on the first three of these factors in this first article.
Our Darkest Hour
Telling clients what their core beliefs or assumptions should be is, I find, usually an excellent way of upsetting a relationship. However, asking whether possible questions and scenarios have been fully considered, and logical implications and conclusions drawn can be fruitful.
One such scenario would currently be: “If we were to see significantly higher tenant defaults than is currently the case, what are the answers to each of the following:
- Can your systems model the effect of a particular tenant default across all properties/
- Do you know in what circumstances there would be a technical breach under any of your loans group/fund wide (whether on/off balance sheet, recourse or non-recourse) and what the cure periods and remedies are in each case?
- Do you know which or in what circumstances loans/assets/hedges could be cross-defaulted?
- Do you automatically monitor covenant breaches and does your system cater for the varying backward looking, forward looking, variable period covenant testing etc and differing income and cost calculations (including bank charges and hedge values) for each loan?
- Do your systems alert you when there may be future covenant breaches from scheduled changes in say ICR/DSCR etc?
- Do tenant defaults at asset level automatically feed into Liquidity Tests at appropriate levels within the group/fund?
- Does a tenant default automatically change or highlight a property’s valuation in your systems?
- Do you have early warning systems in place to evaluate/ monitor (weak) tenants and possibly renegotiate terms?
- When would you know that a tenant has not paid its rent?
Other questions could include:
- Which (parts of) your systems & processes are spreadsheet based?
- To what extent do (parts of) your systems & processes require manual inputs?
- How regularly is information updated?
- To what extent are you able to scenario plan?
- Can you easily assess all your loans, interest rate hedges and other derivatives using a variety of criteria?
It may well be the case that you have been fortunate enough to experience only limited defaults to date and/or a significant amount of your debt is currently floating (thereby providing sufficient cash-flow headroom) but are you comfortable that a significant deterioration in tenant defaults, interest rates or values would be assessed and catered for in a timely fashion?
In any event, and looking forward for a moment, are future new investors going to accept spread- sheet-based monitoring & reporting systems as being adequate and is the extent to which your systems can undertake sophisticated “what if” analyses etc sufficient, especially if other managers do provide such “best in breed” components.
Property Investors’ Confidence
As already mentioned, property investors are going to be far more selective when choosing investment managers. Sure, a significant part of their decision-making will be assessing a manager’s track record (and in particular who actually sold assets ahead of the fall, who made returns from asset management rather than from high leverage only and who did NOT buy during the period of over-valuation despite the temptations!). But an important part of their decision-making process is already focussing on other issues such as transparency, (decision- making) processes and appropriateness of systems as well as other governance issues.
Part of these changes are cyclical – it has been very easy for managers to raise funds for property in recent years and, as a result, terms for investors became progressively less favourable. Investors ignored or were unaware of relatively poor systems and corporate governance in the rush to be invested in the market. Recent events have highlighted some of the major excesses and the degree to which even the basics were largely ignored by some managers. Better and more coordinated systems and processes are required and if you wish to attract future investors, having a great manager will not be enough.
Property Derivatives have been around for some years, particularly in the UK, where there has been a great source of data, namely the IPD UK Property Indices around which to base such instruments. Originally the main constraints to their development were:
- A lack of understanding and distrust by property managers as to their uses,
- Concerns regarding basis risk given the individuality of each property asset whilst the main contract was a Total Return Swap on the IPD UK All property index, and
- Formal authority to use such instruments not being in existence
Managers are now generally much more aware of their potential uses and the credit crunch and associated events have demonstrated an extremely high performance correlation between all sectors, reducing the basis risk difficulties. Additionally various sub-indices are now priced and to some degree tradable and products other than total return swaps are now available. As their usage has become more widespread, the required technical changes to articles & procedures to allow derivatives to be used have become common and less costly.
As well as being able to be used to both gain exposure to a market/sector quickly and hedge existing exposures, property derivatives can also be used as an indicator of future performance and valuations and have proved to be far more accurate in predicting the timing and extent of the downturn than agents’ forecasts. They should, therefore, form an integral part of any property managers’ armoury.
Current usage constraints now generally fall into three categories:
- Lack of integration into decision-making generally. Most funds/groups almost certainly do not have a mechanism for integrating property derivatives pricing into their decision-making, monitoring & valuation processes.
- Lack of systems to trade & monitor property derivatives and associated collateral and counter- party risks. Many multi-asset managers and traditional real estate only companies/funds simply do not have these systems in place.
- Lack of experience in negotiating associated ISDA documentation. Whilst this is often the case for pure property operators, the documentation has become much more standardised and therefore less costly to negotiate and additionally property notes have been developed which do not require such documentation.
Constraints have largely therefore moved from philosophical unease to practical & cost issues. Now, even for relatively small operators, there are cost-effective solutions available, particularly when their integral role in future value monitoring and decision making is considered. For multi-asset managers with real estate activities who have traditionally had very different systems from other managed assets, and who are now beginning to consider much more integrated systems, the marginal cost of catering for property derivatives should be especially low if planned and executed correctly.
Many of the above issues can be categorised as part of a general investor requirement for improved Risk Governance and the property industry is not immune from this. Indeed (apart from perhaps the Hedge Fund industry) it can be argued that more improvement is needed here, precisely because relatively little has been done in the past due to its non– mainstream, specialist and (until recently) highly performing nature.
Many investors (or at least their trustees) will either stay on the sidelines or be highly selective unless firms ensure that they have governance structures and processes in place to measure not only investment, but also counter- party and operational risks as well. This means having the correct (and correctly educated) committees and management information systems capable of reporting on these risks and managers must be able to calculate their firm-wide exposures to a variety of risks as a basic rule of operation.
It is also clear that property does have significant peculiarities and it is therefore vital that when considering such structures, processes and systems, that the planning and implementation teams contain appropriate personnel from various disciplines and front/back offices, otherwise the process will be unnecessarily painful, time-consuming and costly. For multi-asset managers, where their property arms have been largely separate system-wise in the past, this is particularly the case.