When the collapse of Lehman Brothers in 2008 caused sentiment on international property markets to take a nosedive, investors rarely had any reason to celebrate their successes with champagne. In the past three or four years, though, they have again been cracking open the bubbly more often. Politically willed low interest rates and stable letting markets, as well as yields that are adequate by comparison with other asset classes, have sparked a veritable investment boom. However, an end to this blissful state of affairs is not far off. The issue of interest rates, in particular, is creating hangovers. “The present level of interest rates is making it hard for investors to continue achieving adequate yields. At the same time, it offers only a limited reflection of the true market risks,” says Sven Bienert, Professor at the IREBS International Real Estate Business School at the University of Regensburg. The danger of growing discrepancies between rental and investment markets is rising, and with it, so is the possibility of price bubbles, he believes. “The real estate industry has to do its homework now and not put it off. As always, the party will not last for ever.” Bienert, who is also head of the real estate commission at the Deutsche Vereinigung für Finanzanalyse und Asset Management (German Association for Financial Analysis and Asset Management, DVFA), recommends monitoring the risks of interest-rate changes closely and dealing with them proactively.
In the end, you define the extent to which individual risks will be tolerated.
This also applies to the management of open-ended real estate funds, because interest-rate changes affect the assets in a fund both directly and indirectly. “Directly, the level of interest rates affects liquidity and expiring loans,” says Heiko Beck, COO and Member of the Management Board at Union Investment Real Estate GmbH. It has a knock-on effect on rental income and the market values determined by independent experts. The respective risks are managed in a correspondingly varied range of ways. In order to be able to respond quickly and flexibly to changes in interest rates, it is advisable to invest a fund’s cash reserves mainly on a short-term basis. Credit positions are monitored constantly; and scenario analysis helps to determine at what level of interest rates it makes economic sense to redeem a loan. “The biggest challenge is to have scenarios for short-term and medium-term developments in interest rates in the relevant markets and to use these to ascertain the impact on individual assets in the portfolio,” COO Heiko Beck explains, warning: “With good early detection, you have a relatively long time to initiate control measures, but if you allow time to pass, there are no quick solutions!”
Complex management task
This applies not only to interest-rate risks, but also to all the other types of risk that fund managers have to keep in their sights. These include endogenous risks stemming, for example, from the technical and structural quality of the portfolio itself or from the problems involved in what is known as maturity transformation. This arises because open-ended real estate funds take capital from their customers that has been placed in a relatively short-term account and transform it into a long-term property investment. Therefore, capital inflows and outflows have to managed so as to ensure that neither too much nor too little liquidity becomes a problem. Finally, exogenous risks have an important part to play: market influences such as the present low level of interest rates, but also political and regulatory uncertainties. “The risks mentioned have to be managed both individually and in the overall context of the portfolio,” explains the Union Investment manager Beck. This is simply impossible without an understanding of the dependencies and interactions among the influencing factors, he adds. “With a large retail fund such as UniImmo: Europa, to put it in a simplified manner, you have the complexity and risks of a securities fund, plus the risks of the real estate portfolio,” Beck continues, summing up the nature of the challenge.
This applies fundamentally both to large retail funds and to smaller institutional funds, he notes. “However, the complexity of the risk-management task is naturally much greater for a major flagship fund that is active in a variety of currency zones with participation and financing structures than for an institutional hotel fund that invests mainly in the eurozone,” Beck says. Conversely, he continues, the risk-bearing capacity of a large retail fund is greater than that of the institutional fund, because of its broader diversification and sheer size. This, he says, means that, for institutional products, the concentration of risks is often greater – and the fund accordingly more risk-sensitive – than for the industry’s heavyweights. Furthermore, he notes, with institutional products it is necessary to take account both of regulatory demands and of customers’ own supervisory requirements, especially in the case of banks and insurance companies. “However, in open-ended real estate funds, institutional customers are perfectly happy to accept cluster or currency risks. They then compensate for these within the overall context of all their investments,” Beck explains. Nevertheless, in the end it is vital, in both institutional and retail funds, to define the extent to which individual risks will be tolerated and the point at which counter-measures need to be initiated, Heiko Beck says, describing the process.
The present level of interest rates offers only a limited reflection of the true market risks.
The key point here is this: risk models can be only as good as the assumptions on which they are based. Also, forecasts are susceptible to error, especially when they revolve around an assessment of exogenous risks. Therefore, Martin Brühl, Head of Investment Management International at Union Investment Real Estate GmbH, is convinced that “you always have to ask yourself whether you can protect an investment against exogenous influences, and if so, how”. The DVFA’s real estate experts are looking into the same question and coming to the conclusion that, naturally, no protection can be expected in the event of existing price bubbles or geopolitical risks. However, genuine protection of assets is possible even in a deflationary environment. Also, even periods of political upheaval do not condemn property investors to inactivity, as one example from Union Investment demonstrates.
In May this year, the Hamburg-based fund initiator secured a 50-percent holding in the London office building Watermark Place in a joint venture with Canada’s Oxford Properties Group. The fundamentals for this Class A building with more than 50,000 square metres of rental space were compelling. The only problem was that the acquisition co incided with the British general election. “We were relieved by the clear formation of a government afterwards – and, ultimately, the choice made in the election has had a positive influence on our business,” says the Union Investment expert Brühl. Even a “Brexit” – a British exit from the EU, on which the people of Britain are to vote in 2016 – would be “for us, a scenario that we can manage”. He believes it would be short-sighted to look only at the risks, because the opportunities that present themselves in a more complex market environment are at least as great. Brühl puts it this way: “There is no such thing as a real estate business without risks, but our task is to manage the capital that has been entrusted to us responsibly.” For this reason, Heiko Beck of Union Investment identifies the three deadly sins of a risk manager as follows: “First, putting your faith solely in historical data. Second, working only with smoothed averages. Third, disregarding current political, economic and market-specific developments and focusing exclusively on your own microcosm.”