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The Actuary The magazine of the Institute & Faculty of Actuaries

Risk analysis in the property industry

Total returns on all property were 9.7% in 2002, according to data from the Investment Property Databank (IPD), in line with gilt returns and way ahead of equities. Over the past five years, property has outperformed both gilts and equities to provide the strongest real rate of return since the 1980s at 8.2% per year. Unsurprisingly, this has led to renewed interest among investors in property as an asset class.
Outperformance is only part of the picture. As investors have learnt to their cost, high returns can sometimes involve unacceptable risk. Property has been out of favour with asset allocators since the late 1980s boom when growth of 2030% per year was followed by three years of negative returns.
So can commercial property combine satisfactory performance with acceptable risk?
Risk can be considered here in four contexts:
– Property versus other asset classes
– Structural factors
– Risk specific to the individual property
– Risk specific to the fund or portfolio

Property compared with other UK assets
Commercial property has several ‘safe-haven’ attributes compared with other asset classes.
n Property has low volatility Data from IPD shows property has a lower volatility than all major asset classes, except cash. In fact, the degree of volatility, as measured by the standard deviation in total returns, is decreasing over time (see table 1).
n Property offers diversification benefits The correlation between property and the other major UK asset classes is very low. In contrast, the relationship between gilts and equities is much stronger (see table 2).
n Property offers a high and secure income stream The income return from property has averaged 7% per year over the past five years. The existence of long leases, five-year rent review periods, and upward-only rent reviews adds to the security of the income stream.

Commercial versus residential property
It is important to distinguish between commercial property and the much larger residential sector. Conditions in the latter market sometimes influence official pronouncements about property generally, and may have heightened the risk perceptions of commercial property unnecessarily. The continued strength of the residential housing market is driven by capital value growth, which is dependent, in a low-growth and low-inflation environment, on low interest rates and rising capital values for its sustainability risky in the medium term. In contrast, commercial property’s performance has been more sound. Last year, capital values rose by 2.6% rather more modest than the 25%+ rates seen for residential property. Speculative development has been limited, and the role of debt funding less pronounced.

Structural factors
The traditional arguments against holding property are:
– it is an illiquid asset as it takes time to buy and sell property; and
– it is ‘lumpy’, ie the lot size of properties makes orderly disposals difficult.
There is clearly an element of truth in these statements and using property in tactical asset allocation is fraught with difficulty.
Strategically, things may be rather different. Merrill Lynch’s report on this topic concludes that liquidity issues should only preclude investment in property where the fund faces sudden and large cash requirements. Asset/liability matching would mitigate against the mature pension scheme facing final determination of its liabilities. However, mature schemes which have ongoing pension liabilities may still benefit from the income-generating characteristics of property: if the liabilities extend to 20 years hence, that really does allow enough time for even the most dilatory property manager to realise the value of the assets. The solution would seem to be improving communication between the asset/liability managers of the pension fund and the property investment managers, rather than rejecting property out of hand.
The property industry is aware of these criticisms of property as an asset class; it has been heavily involved in the creation of property investment vehicles and property unit trusts, to enable investors to obtain access to larger lot sizes and more marketable products. Much still needs to be done, especially in the regulatory field, but these vehicles can offer an opportunity to minimise these risk factors.

Safe as houses
Investors seeking a safe haven have focused on two aspects of property:
– lease structure; and
– covenant strength.
I have already alluded to the lease structure in property, which enables income to be secured over a long period. The average length is 15 years for new leases and more than 70% of new leases have rent reviews at intervals of five years or longer. Rent reviews are still typically upward only, although these clauses are coming under pressure and are unlikely to provide the same degree of protection going forward.
The income stream is worthless if the tenant goes bust, therefore, the second attraction to investors has been the financial security of the tenants occupying institutional-quality premises. Each year, IPD undertakes an analysis of tenant risk in conjunction with Dun & Bradstreet. It divides companies into four risk groups and the percentage in each group is plotted in figure 1. The strong covenant strength of institutional property tenants, compared with the average UK tenant, can easily be seen.

Risk specific to individual properties
The analysis so far has focused on risk at the ‘all-property’ level. For the property investment manager, risk has to be defined much more widely.
There are differences in risk by sector. The risk attached to investment in central London offices (defined as the beta coefficient in this instance) has been 40% above the all-property average over the past 20 years. However, IPD data shows that historically, less than 20% of the outperformance secured by the top quartile funds has been through fund structure. Superior property selection is the key factor driving property performance.
In common with many other asset managers, ISIS analyses risk at the individual property level and has constructed a scoring system. This incorporates the traditional risk assessment criteria of sector lease length and covenant strength but also includes property-specific elements such as the location of the property, the quality of the fabric of the building, and planning considerations. Opportunities to add value through active management and to minimise risk are identified by specialist asset managers who provide regular property specific reports to fund managers.

Risk specific to the fund or portfolio
So risk is being considered from the top down (the whole asset class), and from the bottom up (the individual property). But the pension fund is primarily interested in the fund and the portfolio. Are there other risk factors to be evaluated here?
Most funds undertake property-specific risk analysis but the risk exposure of the fund does not equate to the average of the properties comprising that fund. Therefore, criteria such as maximum lot size, sector spread, or development exposure are imposed to limit fund risk. For example, development can yield a higher return as the developer has full control over the building and can therefore ensure that it fully meets market needs. However, it can be more risky: market conditions can change as the building is being constructed demand for properties can disappear, or the building can take longer than expected to let.
Analysis of fund or portfolio risk goes further than just imposing the above criteria. Covenant strength should be considered along with the degree of concentration of tenancies. The focus on lease length should not obscure the risk attached to a bunching of rent reviews in a particular year. The risk attached to single-let purpose-built property is higher than for multi-occupied buildings.
Having stressed the responsibility of the property fund management industry in the identification and management of risk, there is one area where investors in property may be being lulled into a false sense of security.
It is not unusual for property pension funds to be constrained to a degree to IPD weightings as a means of reducing risks in property investment and achieving performance at least in line with the IPD average. This limitation may not achieve the desired goal. As discussed above, property returns are driven primarily by individual property holdings rather than structure. The inter-quartile difference, ie the difference in performance between funds at the 25% level and the 75% level, for all property is 2.5 percentage points per annum over five years rising to nearly 4 percentage points per annum for industrials and regional offices which are traditionally perceived as relatively risk free. It is possible for top quartile performance in one sector to be less (over a five-year period) than a lower quartile performance in a more attractive sector. Risk control is more likely to be achieved by employing investment managers alert to the issues than by slavishly adhering to sector weightings.

Buying your dream investment
The investment community is moving towards a greater awareness of risk in portfolio performance and the property industry has responded to this. The Investment Property Forum has recently published a major work, Risk measurement and management for real estate portfolios, which analyses the whole issue in a depth not possible here. Property needs to be evaluated at the asset, portfolio, and individual property level in order to measure risk accurately. There are data limitations and considerable work is being done to model and forecast risk and to understand the interrelationships between different types of risk.
So, property has delivered superior performance and it has important characteristics which limit risk. The challenge is to refine and improve risk-management techniques in the uncertain world in which we all live.