Suite 5B Rivaan Center | P.O. Box 2384 – 00606 | Nairobi , Kenya | +254- 708 909 879 | www.iJenga.com
Real Estate Investment Risk ManagementUnderstanding Risk Management Strategies in Real Estate Investing with the
Goal to Mobilizing Local Institutional Capital in Real Estate & the Affordable
Housing Sector
Conference Presentation
October 29, 2020
Agenda
Copyright of iJenga Venture Limited2
1. Real Estate Investment Decisions
2. Risks in Real Estate Investing
3. Risk Management
Definitions
3
• Real Estate: Real Estate is artificially delineated space references to a fixed point on the surface of the earth with a fourth dimension of time. It is built to house an economic activity that is subject to cultural preferences and restricted by the public infrastructure.
• Real Rate of Return: Equals the nominal rate of return minus the inflation rate, which measures the change in purchasing power provided by an investment
• Expected Inflation Premium: The average rate of inflation expected in the future• Risk-free Rate: The rate of return that can be earned on a
risk-free investment. The most common “risk-free” investment is considered to be the Treasury Bill• Risk: Risk is the magnitude of surprise from expectation. The commonly used statistical measure is
called the standard deviation.
Required return
on investment j=
Real rate
of return+
Expected inflation
premium+
Risk premium
for investment j
Source: Pearson Education Inc
1. Real Estate Investment Decisions
For financial investment, we gauge and compare investment opportunities based on the tradeoff between expected return to the investment and the magnitude of the risk. One wants to investment in projects that generate high expected returns, with low risk.
Discussion on asset class allocation
4
1. Real Estate Investment Decisions
Asset class allocation is the process of deciding how to distribute wealth among asset classes, sectors, and countries for investment purposes. This is not an isolated choice, but rather a component of the portfolio management process.
Choices will be determined by:• Capital market expectations• Risk tolerance• Financial needs
Investment Strategies include:Active• Trying to secure better than average performance• Active asset allocation• Active security selection• Must balance likelihood of better returns with costs in
highly competitive markets.
Passive• Trying to get average returns rather than do better than
the market• Mix of Passive and Active (Passive core, active part)• First decision is Asset Allocation Decision
Discussion on asset class allocation continued
5
Asset Class
Risk Characteristics
Public Equity
Market beta/high Volatility
High return/Growth
Private Equity
Illiquid/high Volatility Higher return/Growth
Real Estate (REITS)
Market beta/high Volatility
High return/Growth/Inflation Protection
Real Estate (Private)
Illiquid/regional/Volatile
High return/Inflation protection
Bonds Low Volatility Low return/Risk minimizing
TIPS Low Volatility Low return/Inflation protection
NaturalResources/Real Assets
Illiquid High Return/Inflationprotection
Asset Class Risk-Return Chart
1. Real Estate Investment Decisions
Pension funds can invest up to 70% of funds in real estate through direct property, in REITs or in private equity
6
Asset ClassRBA Max Limit(% of Portfolio)
Cash and Demand Deposits 5%
Fixed Deposits 30%
Listed Corporate Bonds 20%
Commercial Paper, Non-Listed Bonds and other debt instrumentsissued by private companies
10%
East African Government Securities and Infrastructure Bonds issued bypublic institutions
90%
Quoted Stocks in East Africa (Equities) 70%
Unquoted Equities 5%
Offshore (Equities, Fixed Interest, Cash) 15%
Property 30%
Exchange Traded Derivative Contracts 5%
Listed Real Estate Investment Trusts 30%
Private Equity and Venture Capital 10%
Any Other Assets 10%
1. Real Estate Investment Decisions
7
Investment products in real estate can be broken into two categories – supply side and demand side
Source: RBA, CMA
Real Estate Investment
Supply Side
Direct Investing
• Developers’ Equity
Indirect Investing
• REITs
• Private equity
• Equity share in developer
• Infrastructure
Demand Side
Indirect Lending
• Mortgage Refinance Company
• Mortgage Backed Securities
1. Real Estate Investment Decisions
8
Investment products in real estate
Source: RBA, CMA
Investment Product
Description Asset Allocation Threshold
Benefits Limitations
Provision of Developers Equity
This involves investing directly in real estate property. May be medium to long term depending on the exit strategy (sales vs rentals)
30% • Potentially higher returns given exposure to developer return upside on capital appreciation
• Provides higher control on the property assets
• High due diligence costs given opacity of industry
• Vulnerable to developer risk
• Incur taxes on income distribution on exit
REIT Investments
REITs are financial instruments that allow investors to indirectly invest in property. They can be traded on a stock exchange.
30% • Lower entry costs• Higher tax efficiency for
investors• Higher liquidity• Higher transparency• Greater ability to diversify
investments by asset class
• Subject to a management fee
• Lack the level of control available in direct property investment
• Have a higher correlation with stockmarkets
Real Estate Private Equity
A general partner and limited partner structure that manages institutional money and makes strategic, direct investments in property.
10% • Return on capital can be significant in the long term
• Provides an opportunity to diversify investments by asset class
• Involves significant upfront capital
• Lack of control for the limited partner with regard to what assets are acquired or sold
• Subject to a management fee
1. Real Estate Investment Decisions
9
Investment products in real estate continued
Investment Product
Description Asset Allocation Threshold
Benefits Limitations
EquityInvestment in Developer
This refers to an equity investment in a real estate developer. (either public or private)
10 – 70% depending on
whether the firm is locally listed
• Provides exposure to a resilient industry while maintaining the benefits of a stock including liquidity and transparency where the stock is publicly traded
• Exposed to market risk on share prices
• Investors have no exposure to real assets and can’t take advantage of capital gains
InfrastructureDebt
Refers to investment in physical structures that are essential for operation of society
10 – 90% depending on the issuer (public vs
private)
• Provides diversification benefits from other assets
• Provides steady cashflows • Useful as an inflation hedge• Useful in showing commitment
to ESG principles• Potential tax benefits if issued
by government
• Limited returns compared to other alternative investments
MortgageBacked Securities (KMRC)
Pension funds could invest indirectly in real estate by buying assets backed by mortgage loans from banks. An example of this would be an investment in KMRC in a bid to provide long term capital
10% • Security has similar qualities to fixed income investments thus provides a guaranteed rate of return which is still higher than traditional corporate or government bonds
• The investment has lower prepayment risk compared to direct mortgages
• Investment is subject to credit risk
• Returns may be limited compared to other forms of real estate investment
Source: RBA, CMA
1. Real Estate Investment Decisions
10
Benefits of indirect real estate investing
1. Real Estate Investment Decisions
Direct Investing
Real Estate
VS
Investors
Real Estate
Indirect Investing
Investors
Fund Manager / REIT
Benefits of Indirect Investing
• Diversify the risk of holding direct investments in property
• Removes the liquidity risk associated with direct investment in property
• Enables investment in commercial property with relatively small sums of money
• Gains access to professional property investment
• Avoids double taxation
11
Real Estate has a number of property types or asset classes
1. Real Estate Investment Decisions
Various Property Types / Asset Classes
• Multifamily residential• Single Family Residential• Office• Industrial / Flex• Warehouse / Storage• Retail• Recreation• Land – potential uses• Education• Healthcare• Agricultural
12
Each asset class has its own risk-return profile and investment advantages and disadvantages
1. Real Estate Investment Decisions
Risk
Risk-Return by Real Estate Strategy
Various long-term structural changes are emerging that should not be ignored
13
1. Real Estate Investment Decisions
Source: RBA, CMA
Pensions can use various methodology to develop their real estate investment strategy by property type & geography
14
1. Real Estate Investment Decisions
Stage 2:
Stage 3:
Stage 1:
Investment Style Strategy & Geography
Risk LiquidityReturn
Investment Universe
Objectives
Universe
Strategic & Tactical Allocs
Market Selection
Neutral Portfolio
Optimizations: Constraints & Risk Profiles
Allocations by Property Type & Geography
…
What distinguishes property from other asset classes?
15
Each individual property is unique – location, structure, size and design
It is subjective – individuals find different characteristics attractive and there is no central marketplace
Subject to complex legal considerations and transaction costs are high
Highly illiquid - it can take a considerable amount of time to buy or sell a property. The investor also has to sell the whole property or nothing at all.
Property can only be purchased in discrete and generally sizeable and relatively expensive units, making diversification difficult – only institutional investors can do this effectively
Supply of land is finite and its availability can be further restricted by legislation and local planning regulations. Price of property is heavily driven by changes in demand and not supply.
Nature
Value
Transfer & Settlements
Liquidity
Diversification
Effects on Price
1. Real Estate Investment Decisions
Investing in real estate has various advantages…
16
1. Real Estate Investment Decisions
Source: Waypoint Residential - Direct Real Estate in a Portfolio
… but it also has various disadvantages
17
1. Real Estate Investment Decisions
1. Investments are illiquid and can be a hard to devest when markets are experiencing
challenges
2. Requires active property & asset management
3. Assets are constantly depreciating in value and require active maintenance to retain value
4. Property is heavily regulated and subject to government controls
5. Real Estate investment is a medium to long term investment horizon and is subjective to
market cycles
6. Each property requires its own legal structure, which vary by partner, jurisdiction and
complexity
7. Objective information sources about property can be difficult to obtain
8. Comparable property data is limited
9. Reliable price quotations are not available on a frequent basis
10. There are typically only a select amount of buyers/sellers in a market
11. Transactions are cumbersome, time-consuming, inefficient, etc.
Investors can use an investment process feedback loop to invest and monitor investments by property type and geography
18
Planning
• Identify & investment objectives & constrains
• Create investment strategy
• Form capital markets expectations
• Create asset allocation
Execution
• Asset allocation
• Securities selection
• Implementation & execution
Feedback
• Monitoring
• Rebalancing
• Performance evaluation
Source: The Portfolio Management Process and the Investment Policy Statement
1. Real Estate Investment Decisions
Its important to understand the stage, product, use and lifecylcleof investment
19
Cash
Flow at
Sale
Cash Flow
From
Operations
Initial
Cost
Cashflow Characteristics of Real Estate Investment
1. Investment and Investment Analysisa. Capital Assetsb. Equityc. Debtd. NOIe. Lender/Equity Relationf. Maximizing Wealthg. Return and Risk
2. Feasibility and Feasibility Analysisa. Site in Search of a Useb. Use in Search of a Site
3. Investment Life Cyclesa. Property Life Cycleb. Ownership Life Cyclec. Investor Life Cycle4. Ownership Life Cyclea. Acquisitionb. Operationc. Disposal/Termination
1. Real Estate Investment Decisions
Investments at various stages of real estate development and management have different levels of risk
20
Perm
itti
ng
Co
nst
ruct
ion
Stabilized Operations
Pre land acquisition and Construction are the highest risk phases. The risk reduces significantly once the development is complete and in Lease-up.
1. Real Estate Investment Decisions
Levels of Risk at Various Stages of Development & Management
Structures of cost uncertainty – shades of gray
21
1. Real Estate Investment Decisions
The Spectrum of Cost Uncertainty
Source: Real Estate Principles: A Value Approach Ling and Archer
Structures of cash flow uncertainty – shades of gray
22
1. Real Estate Investment Decisions
The Spectrum of Cash Flow Uncertainty
Source: Real Estate Principles: A Value Approach Ling and Archer
Agenda
Copyright of iJenga Venture Limited23
1. Real Estate Investment Decisions
2. Risks in Real Estate Investing
3. Risk Management
Market Risks
24
2. Risks in Real Estate Investing
Background
All markets have ups and downs tied to the economy, interest rates, inflation or other market trends.
Investors can’t eliminate market shocks, but they can hedge their bets against booms and busts with a
diversified portfolio and strategy based on general market conditions.
The risk associated with real estate investments is primarily determined by the uncertainty of the value of the
property involved. Property and property-related assets are inherently difficult to appraise due to the
individual nature of each property and due to the fact that there is not necessarily a clear price mechanism.
As a result, valuations may be subject to substantial uncertainties. There is a risk that the estimates resulting
from the valuation process will not reflect the actual sales price. As such, a property market recession could
materially adversely affect the value of the property.
Mitigation Strategies
• Active research on economic cycles
• Strategic investment and disposition of assets
• Cash reserves for ‘rainy days’
• Sensitivity analysis on investment to model downside risk and returns
Asset-Level Risks
25
2. Risks in Real Estate Investing
Background
Asset-level or business risk involves changes in the occupancy rates, level of new construction, and zoning
and permit regulation, as well as additions to the competitive supply. Oher risks include labor problems and
moratoria on types of utilities like gas, sewers, water and electricity.
Differences among customers and building practices may result in losses due to construction delays, the
failure to obtain permits, and behavior of labor and supervisory personnel.
Some risks are shared by every investment in an asset class. In real estate investing, there’s always demand
for apartments in good and bad economies, so multifamily real estate is considered low-risk and therefore
often yields lower returns. Office buildings are less sensitive to consumer demand than shopping malls, while
hotels, with their short, seasonal stays and reliance on business and tourism travel, pose far more risk than
either apartments or office.
Mitigation Strategies
• Active portfolio management and economic / sector research
• Strategic investment and disposition of assets
• Experienced consultant and contractor teams and strong contracts
• Diverse portfolio of cyclical and recession resistant assets
Idiosyncratic Risk
26
2. Risks in Real Estate Investing
Background
Idiosyncratic risk is specific to a particular property. The more risk, the more return.
Construction, for example, will add risk to a project because it limits the capacity for collecting
rents during this time. And when developing a parcel from the ground up, investors take on
more types of risk than just the construction risk. There’s also entitlement risk – the chance that
government agencies with jurisdiction over a project won’t issue the required approvals to
allow the project to proceed; environmental risks that range from soil contamination to
pollution; budget overruns and more, such as political and workforce risks. Location is another
idiosyncratic risk factor.
Mitigation Strategies
• Robust feasibility study with in-depth understanding of neighborhood market
• Experienced consultant and contractor teams and strong contracts
• Diverse portfolio of cyclical and recession resistant assets
Liquidity Risk
27
2. Risks in Real Estate Investing
Background
Liquidity risk reflect the amount of time required to liquidate an investment. Real estate has a
relatively high degree of liquidity risk given the size of investment and the number of investors,
depending on the local market conditions. Even normally liquid markets can become illiquid
when they experience extraordinary events, such as events like market crashes, pandemics, or
market cycles.
Mitigation Strategies
• Robust feasibility study with in-depth understanding of neighborhood market
• Strategic investment and disposition of assets
• Good quality brokers and consultants to help facilitate a professional disposition of asset
• Diverse portfolio of cyclical and recession resistant assets
Leverage Risk
28
2. Risks in Real Estate Investing
Background
The more debt on an investment, the more risky it is and the more investors should demand in return.
Leverage is a force multiplier: It can move a project along quickly and increase returns if things are going well,
but if a project’s loans are under stress – typically when its return on assets isn’t enough to cover interest
payments – investors tend to lose quickly and a lot. As a rule, leverage should not exceed 75%, including
mezzanine and preferred equity, because both of these types of debt sit ahead of common equity in payment
order. Returns should be generated primarily from the performance of the real estate – not through excessive
use of leverage – and it’s critical that investors understand this point.
Similarly, structural risk is to be noted. A senior secured loan gives a lender a structural advantage over
“mezzanine” or subordinated debt because senior debt is the first to be paid; it has top place in the event of
liquidation. Equity is the last payout in the capital structure, so equity holders face the highest risk. Structural
risk also exists in joint ventures. In these types of deals, the investor has to be aware of their rights relative to
their position in the LLC, which is either a majority or minority holding.
Mitigation Strategies
• Conservative leverage ratios and cost efficient capital structure
• Robust feasibility study with in-depth understanding of neighborhood market
• Robust sensitivity analysis to understand downside risk in poor market conditions
Credit Risk
29
2. Risks in Real Estate Investing
Background
The length and stability of the property’s income stream is what drives value. A property leased
to a Grade A company for 30 years will command a much higher price than a multi-tenant office
building with similar rents. However, keep in mind that even the most creditworthy tenants can
go bankrupt, as history has shown us time and time again. The more stability in a property’s
income stream, the more investors are willing to pay because it behaves more like a bond with
predictable income streams. However, the triple-net lease landlord is taking a risk that the
tenant will stay in business for the length of the lease, and that there will be a waiting buyer.
Mitigation Strategies
• Conservative leverage ratios and cost efficient capital structure
• Active tenant, property and asset management
• Robust feasibility study with in-depth understanding of neighborhood market
• Robust sensitivity analysis to understand downside risk in poor market conditions
Regulation Risk
30
2. Risks in Real Estate Investing
Background
Regulatory amendments may affect prospects for the future lease of the premises, or prospects for the future
sale of the property. New technical or other requirements (including health and environmental requirements)
pertaining to the property may also impose costs on the company or individual that cannot be recouped from
the tenants. Time to time, relevant tax rules, or the application of rules may change. Amendments to tax
rules may result in investors being faced with new and different investment conditions, including reduced
profitability of the project.
Also, delays in the planning approval process increase the above mentioned time risk. At a time like this when
government parastatals such as land registries remain closed due to the ongoing novel coronavirus pandemic,
projects are set to be delayed indefinitely prolonging set project timelines and ultimately leading to increased
development costs as debt costs continue to accumulate. Additionally, all development is subject to planning,
and while developers, in general, apply for permissions that are in line with official planning rules and
development plans, the multitude of affected stakeholder interests can lead to specific conditions that affect
the cost and feasibility of a project. The approval process should be project managed professionally to
minimize this risk.
Mitigation Strategies
• Experienced consultant and contractor teams and strong contracts
• Conservative workplan with contingency planning incorporated
• Robust sensitivity analysis to understand downside risk in poor market conditions
Time Risk
31
2. Risks in Real Estate Investing
Background
Exceeding the planned project timeline leads to two main risks: cost of capital such as interest
increases with delays reducing project returns, and market conditions may change over time for
the worse. This is especially relevant as usually, top of the market conditions trigger developers
to pursue marginal opportunities. As markets turn and consolidate, delays in the completion of
such projects aggravate losses. The time risk can be addressed by professional best practice
project management including, selection of experienced and qualified project management
teams, clear documentation, coordination, and communication between project parties, and
timely commencement of marketing. An overall understanding of market forces and dynamics is
also critical.
Mitigation Strategies
• Experienced consultant and contractor teams and strong contracts
• Conservative workplan with contingency planning incorporated
• Robust feasibility study with in-depth understanding of neighborhood market
• Robust sensitivity analysis to understand downside risk in poor market conditions
Agenda
Copyright of iJenga Venture Limited32
1. Real Estate Investment Decisions
2. Risks in Real Estate Investing
3. Risk Management
Risk Management as an institutional program
33
Risk Management Strategies
Risk Avoidance• Avoid the chances of loss by shifting the risk to
counter parties by creating incentives for performance and disincentives for poor performance
Risk Anticipation• Position part of your portfolio to protect against
anticipated risk factors, by maintaining cash reserves, structure strong contracts and actively managing risks
Risk Transfer• Insurance and other investment vehicles can
allow for the transfer of risk, often at a price, to another investor who is willing to bear the risk
Risk Reduction• Effective diversification and asset allocation
strategies can reduce risk, sometimes without sacrificing expected return
Risk Management Processes
• Identify Risk factors• Quantification of exposure to risk• Map various risks in to risk estimation
calculation• Identify overall risk exposure• Continuous measurement of exposure• Adjustment to exposure according to
agreed risk exposure limits• Alteration based on new information• Investment decisions are based on better
risk adjusted returns and downside risk protection
• Investment portfolio is diversified across asset classes, markets, and strategies to mitigate risk
• Manager selection is based on stringent quantitative and qualitative due-diligence
• Risk reporting is part of the culture
3. Risks Management
Yield Investment Risk Analysis
34
Disposition /
Sale
Cash Flow
From Operations /
NOI
Investment
Cash Flow from Operations / Net Operating Income
Revenue Items
• Contract rents (not market rents) for leased periods
• Vacancy and collections based on lease contracts, with sensitivity analysis
Expense Items
• Include all expenses like property taxes, operating expenses, depreciation allowances, capital improvement expenditures (replacement reserves)
• Efficient capital structuring to minimize interest eexpense
• Before-Tax Cash Flow and After-Tax Cash Flow
Investment
• 3rd party valuation
• Robust market analysis
• Realistic exit analysis
• Expansive sensitivity analysis with focus on downside risk
• Multiple levels of investment review
Disposition
• Aggressive paydown of debt during investment life
• Planned timing and strategy of sale to maximize price
• Good sales broker to ensure professional process
• Due diligence of buyer to ensure smooth transaction processing=
3. Risks Management
Development Risk Analysis
35
Project Feasibility
FinancingAsset
Management Design & Approvals
Construction & Delivery
Offtake Management
Using iJenga’s proprietary integrated development methodology we can highlight key areas of risk and various risk management strategies, like stage gates, quality team, cost effect finance, robust contracts, threshold offtake, and good construction and project management (CM & PM)
Stag
e G
ages
& R
isk
Mgt
A robust feasibility study should define in detail the strategy, including market, offtake, financials, team, timelines, implementation, and risk management.
An experienced team can save a development a lot of rework, time and energy
Front loading developers equity will ensure the developer is invested in the project
Good construction contract terms and strong CM & PM can manage site risk
Threshold presales / offtake before construction start can manage construction risk
Active dialog with govt can manage regulatory risk
Well structured finance and capital management can keep interest cost down
3. Risks Management