Managing Risk In Cycricalbusiness Jd Uli Risk

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captial markets

J ay n e L . D ay

Managing Risk in a Cyclical Business Building a strong risk management practice and integrating it throughout a business can help businesses survive and thrive in the long term.

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In the “easy money” environment of the first half of 2007, profits could be had from rising real estate prices, as an ocean of liquidity lifted all ventures. Now that the tide of liquidity has receded, dangers are much closer to the surface. The credit crunch that began last August highlighted the strengths and weaknesses of risk management in the commercial real estate industry. Since then, many investors and lending institutions have encountered financial difficulties, in part because of weak and ineffective risk management practices. At many companies, the problems were exacerbated by risk management groups with little real authority or that labored under inappropriate reporting structures. At some firms, risk managers reported to, and were overridden by, business leaders who wanted to close deals. The traditional objection to risk management is that it is “the art of getting to ‘no.’ ” Proper risk management helps create sustainable deals that can turn a profit for all parties involved. Risk management is truly put to the test in a declining real estate market, where the best outcomes are often things that don’t happen. A primary goal of any risk management function should be to provide a rigorous and consistent process that drives long-term business growth. Risk management should proactively communicate the standards and guidelines for deals that a company wants to attract and pursue. In commercial real estate, a thorough risk management process often starts with a top-down view of the marketplace. An analysis of regional and national economic forecasts can often set the overall context in which lending and investing decisions are made. On a micro level, each potential property deal needs careful scrutiny.

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This bottom-up assessment needs to be as exhaustive as is practical, covering the actual and potential risks associated with environmental, structural, and insurance issues. In addition, the risk management function should conduct a credit evaluation of customers, borrowers, co-investors, primary tenants, and all other parties with a financial role in the transaction. The results of these evaluations can then be factored into the critical function of determining sustainable income for a property and its competitive position within a local market. Consistency in application of principles in determining a fully vetted property valuation forms the basis of any intelligent investment decision. Finally, risk management needs to take a step back and look at all of a company’s holdings to avoid overexposure to any one particular city, asset class, or economic sector. One of the keys to a successful risk management program is open communication with the internal deal team—origination, underwriting, and asset management—as well as with the customer. Open dialogue can provide clarity on market risk for all the participants involved—and this can help the players understand the individual transaction better, and form realistic expectations for timetables and deal outcomes. In turbulent economic times, a strong risk management discipline provides a basis for making defensive decisions. For example, there were relatively few trans­actions during the first half of the year because significant uncertainties existed in the markets. At that stage of a market cycle, sellers often will not discount heavily enough to compensate for the market uncertainty. Only when a seller faces distress—as in a defaulted loan— can opportunities arise. In general,

making investment decisions in a falling market is extremely challenging because the information one has is never sufficient. Rapidly falling market occupancy, which typically precedes rent declines, is clearly a red flag for investment. Yet, it is hard to know whether values will fall another 10 percent, 20 percent, or even more. In times such as these, it is best to seek stability in markets that investors know well. If one’s investment horizon is longer than the anticipated downturn, it is easier to identify and seize opportunities; significant profits can be made by those who dare to buy when no one else does. Though it is impossible to “time” the bottom of the cycle, the traditional signs that a downturn has ended include stability in occupancy rates and rental rates for two quarters. On a macro level, another important indicator is when national employment levels stop falling. Striking a deal for a good property at the right price with a customer who has real estate experience and liquidity does not mean that all risks have been covered. Monitoring the many remaining risks is also part of the responsibility. Three risks merit a closer look: l Concentration risk. Having a high proportion of properties in a single geographic market or a single asset class is a risk that is hard to protect against. Also, having a high percentage of a portfolio in a single asset also presents problems. For example, many investors have a bias for large trophy buildings, which hold their value for the most part through cycles. However, to make an error on a very large building versus many smaller ones can really devastate a portfolio. l Industry concentration. The assumption is that a portfolio is adequately diversified if it is split

between, say, Boston and San Francisco. But because both markets are driven by the financial services industry, this is really not the case. Many similar pairings of different markets are affected by the same external factors. l Green risk. What risk could “green” buildings pose? The risk may be the opportunity cost if a building is the last to go green in a market. Going forward, the more green structures there are, the less competitive nongreen buildings will be. Green buildings may carry a rental premium if they allow tenants to save on operating costs over time. The premium may also be partially attributable to the perception that they are healthier places to work. When a cost-benefit analysis of being green is taken into account, a lot depends on what is going on in a particular market. One of the most important and rewarding aspects of risk management is its growing acceptance in nearly every industry as a critical business function—despite the difficulty of getting it right. As is true of all investment professionals, the best risk leaders are those who have seen the downside, experienced a full market cycle, and know why things go wrong. Risk is also a great place to begin a career in real estate and leads naturally to originations, business development, and asset management. That is because it teaches how to underwrite a property and value it, how to conduct a site inspection, how to build financial models, and how to do in-depth analysis. Building a strong risk management practice and integrating it throughout a business will help investors survive and thrive in the long term. In today’s uncertain economic times, having a viable risk management function can provide a competitive advantage. UL Jayne L. Day is the senior vice president,

chief risk officer at GE Real Estate.



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