Managing Risk in Cycricalbusiness JD ULI Risk

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proactive 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. 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
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  138 URban Land July 2008 proact i  ve Jayne L. day captial markets Managing Risk in a Cyclical Business In the “easy money” environ-ment of the first half of 2007, profitscould be had from rising real estateprices, as an ocean of liquidity liftedall ventures. Now that the tide of liquidity has receded, dangers aremuch closer to the surface. Thecredit crunch that began last Augusthighlighted the strengths and weak-nesses of risk management in thecommercial real estate industry.Since then, many investors andlending institutions have encounteredfinancial difficulties, in part becauseof weak and ineffective risk manage-ment practices. At many companies,the problems were exacerbated byrisk management groups with littlereal authority or that labored under inappropriate reporting structures. Atsome firms, risk managers reportedto, and were overridden by, businessleaders who wanted to close deals.The traditional objection to riskmanagement is that it is “the art of getting to ‘no.’ ” Proper risk man-agement helps create sustainabledeals that can turn a profit for allparties involved. Risk managementis truly put to the test in a declin-ing real estate market, where thebest outcomes are often thingsthat don’t  happen.A primary goal of any risk manage-ment function should be to provide arigorous and consistent process thatdrives long-term business growth.Risk management should proactivelycommunicate the standards andguidelines for deals that a companywants to attract and pursue.In commercial real estate, athorough risk management processoften starts with a top-down viewof the marketplace. An analysis of regional and national   economicforecasts can often set the overallcontext in which lending and invest-ing decisions are made.On a micro level, each potentialproperty deal needs careful scrutiny.This bottom-up assessment needsto be as exhaustive as is practical,covering the actual and potentialrisks associated with environmental,structural, and insurance issues.In addition, the risk managementfunction should conduct a creditevaluation of customers, borrowers,co-investors, primary tenants, andall other parties with a financial rolein the transaction.The results of these evaluationscan then be factored into the criticalfunction of determining sustain-able income for a property and itscompetitive position within a localmarket. Consistency in application of principles in determining a fully vettedproperty valuation forms the basis of any intelligent investment decision.Finally, risk management needs totake a step back and look at all of acompany’s holdings to avoid over-exposure to any one particular city,asset class, or economic sector.One of the keys to a successfulrisk management   program is opencommunication with the internaldeal team—srcination, underwriting,and asset management—as well aswith the customer. Open dialoguecan provide clarity on market risk for all the participants involved—andthis can help the players understandthe individual transaction better, andform realistic expectations for time-tables and deal outcomes.In turbulent economic times, astrong risk management disciplineprovides a basis for making defen-sive decisions. For example, therewere relatively few transactionsduring the first half of the year because significant uncertaintiesexisted in the markets. At that stageof a market cycle, sellers often willnot discount heavily enough tocompensate for the market uncer-tainty. Only when a seller facesdistress—as in a defaulted loan—can opportunities arise. In general,making investment decisions ina falling market is extremely chal-lenging because the informationone has is never sufficient. Rapidlyfalling market occupancy, whichtypically precedes rent declines, isclearly a red flag for investment. Yet,it is hard to know whether valueswill fall another 10 percent, 20 per-cent, or even more. In times suchas these, it is best to seek stabilityin markets that investors know well.If one’s investment horizon islonger than the anticipated down-turn, it is easier to identify andseize opportunities; significantprofits can be made by those whodare to buy when no one elsedoes. Though it is impossible to“time” the bottom of the cycle, thetraditional signs that a downturnhas ended include stability in occu-pancy rates and rental rates for twoquarters. On a macro level, another important indicator is when nationalemployment levels stop falling.Striking a deal for a goodproperty at the right price with acustomer who has real estate expe-rience and liquidity does not meanthat all risks have been covered.Monitoring the many remainingrisks is also part of the responsibil-ity. Three risks merit a closer look: l Concentration risk. Having ahigh proportion of properties in asingle geographic market or a singleasset class is a risk that is hard toprotect against. Also, having a highpercentage of a portfolio in a singleasset also presents problems. For example, many investors have abias for large trophy buildings,which hold their value for the mostpart through cycles. However, tomake an error on a very large build-ing versus many smaller ones canreally devastate a portfolio. l Industry concentration. Theassumption is that a portfolio isadequately diversified if it is split Building a strong riskmanagement practice andintegrating it throughouta business can helpbusinesses survive andthrive in the long term.   July 2008  URban Land 139 between, say, Boston and San Fran-cisco. But because both marketsare driven by the financial servicesindustry, this is really not the case.Many similar pairings of differentmarkets are affected by the sameexternal factors. l Green risk. What risk could“green” buildings pose? The riskmay be the opportunity cost if abuilding is the last to go green ina market. Going forward, the moregreen structures there are, the lesscompetitive nongreen buildingswill be. Green buildings may carrya rental premium if they allow ten-ants to save on operating costsover time. The premium may alsobe partially attributable to theperception that they are healthier places to work. When a cost-benefitanalysis of being green is taken intoaccount, a lot depends on what isgoing on in a particular market.One of the most important andrewarding aspects of risk manage-ment is its growing acceptance innearly every industry as a criticalbusiness function—despite the dif-ficulty of getting it right. As is trueof all investment professionals, thebest risk leaders are those whohave seen the downside, experi-enced a full market cycle, and knowwhy things go wrong.Risk is also a great place to begin a career in real estate and leadsnaturally to srcinations, businessdevelopment, and asset manage-ment. That is because it teaches howto underwrite a property and valueit, how to conduct a site inspection,how to build financial models, andhow to do in-depth analysis.Building a strong risk manage-ment practice and integrating itthroughout a business will helpinvestors survive and thrive in thelong term. In today’s uncertain eco-nomic times, having a viable riskmanagement function can provide acompetitive advantage. UL  Jayne L. day  is the senior vice president,chief risk officer at GE Real Estate.
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