Lessons learned from the global financial crisis
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26 February 2019
Martin Brühl FRICS, global chair of RICS’ Real Estate Investment Risk Forum, reflects on what the industry has learned since the global financial crisis.
Why is real estate investment risk a burning issue right now?
When I took office as RICS President in 2015, we were in a hot market. It was the perfect time to create a forum in which top decision makers, all of whom are trying to deploy other people’s money responsibly in today’s market, could meet and share best practice.
Two and a half years later we are still in an unusually long cycle, which shows no immediate signs of slowing down 10 years after the global financial crisis. Assets are extremely expensive, and the risks increase the further up the curve you go in search of a higher investment yield. That is a phenomenon all of the forum members have observed, and it is caused by the scarcity of stable, core product. In today’s marketplace, you have to be extremely prudent not to repeat the same mistakes as 2005-6 in taking risks that you have mispriced.
Does that mean a downturn is imminent?
Real estate cycles usually last eight to 10 years, but several clear signals indicate how late we are in this current cycle. Historic record prices have now been exceeded. We are beyond the stabilised long-term averages in whatever we do. The danger of price correction and devaluation is imminent, yet the music keeps playing. People are starting to dance closer to the exit, and it is this awareness of the risks surrounding us that the forum debates among its members and encourages in the wider fund management industry.
“Historic record prices have now been exceeded. We are beyond the stabilised long-term averages in whatever we do. The danger of price correction and devaluation is imminent, yet the music keeps playing.”
Martin Brühl FRICS , Former RICS president
Investment managers whose strategies mandated the buying of core properties in prime markets are moving into secondary and regional markets, because properties in the global gateway cities are scarce and expensive. If people take that to an extreme, we call it “style drift”, and we are seeing it all over the place at the moment.
Managers are also taking on more operational risk, as they are buying alternative asset classes, such as student housing, where there’s risk of the operator going bust. More investors are moving to debt rather than equity investment. Foregoing the higher returns of the latter for the safety of the former is a late-cycle phenomenon.
The lateness of the cycle is also reflected in the way many transactions are being carried out. In some cases, investors have to shortcut due diligence in a way they would never have done in 2010, because they know if they take too long they won’t get the deal. In the late stages, good practice sometimes gets thrown overboard.
What potential shocks pose a danger for property markets?
If we knew what they were, they would not be a “shock”. Joking apart, I believe “black swan” events are often used as an excuse for poor risk management. As fiduciaries to our investors, we need to make sure that our portfolios are as weather-proof as possible.
There are numerous geopolitical risks that could bring parts of the world economy to a temporary standstill. The earth is getting warmer, wetter, and wilder, and the risks resulting from climate change need to be priced into investment decisions. Online retail is a real threat to shopping malls, and tenants’ desire for greater flexibility and better service is starting to marginalise traditional bricks and mortar landlords in the office sector.
We need to build, manage, and continuously improve property portfolios that are resilient to these imponderables by collaborating across professional silos – something RICS has promoted for many years.
Is the industry better prepared for a downturn than it was in 2008?
After the financial crisis, regulators took action to try to avoid a repeat of 2008’s events. That wasn’t always the most productive approach. Regulation has made business more complicated and expensive, and there is a danger this may draw the focus of senior management away from what is happening in the market. Part of the forum’s purpose is to reassure regulators the real estate industry isn’t running in the same direction as 2007.
We are definitely better prepared than before. Companies have introduced risk management functions, and officers who have licence to scrutinise and veto purchases and asset management decisions. A culture of thinking about risk and how to mitigate it has developed. For example, investment managers look far more rigorously at their buy-sell analysis. They are using good phases in markets to sell off the bottom 25% of their portfolio. That makes the whole portfolio more risk-proof, because if something negative happens you are selling good properties, not problematic ones.
“People with short-term memories are making long-term investment decisions. The market will come down at some point, and we need to look at how we prepare our portfolios so they are ready for this.”
Martin Brühl , Former RICS president
The mix of tenants is also important. You wouldn’t want only financial tenants in the City of London at the moment with the concern over Brexit negotiations. It is about risk management at asset and portfolio level. To get diversification in your portfolio, you have to look closely at interdependencies and covariance.
What can be done to further reduce investment risk?
We need to ensure the experience of forum members is shared with people entering the industry, so they learn how to identify the indicators of an overheating market and respond. Some of the younger professionals in our businesses started their careers after the financial crisis and have only seen 10 years of a rising market.
In our industry, people with short-term memories are making long-term investment decisions. The market will come down at some point, and we need to look at how we prepare our portfolios so they are ready for this.
Liquidity management is vital if you are to defend yourself against shocks. Some of my peers in the forum manage open-ended funds with billions of euros of assets under management, much of which is redeemable on short notice. It is also important to be disciplined in terms of the money you allow into your business. Too much liquidity not only causes a dilution of performance, but you can also come under pressure to deploy that capital on assets with inflated prices.
Portfolio analysis tools that are used in other asset classes, like bonds and equities, can be adapted for real estate – but to do that effectively, we need to gather high-quality, comparable real estate market data across borders. Moreover, any professional within any of the real estate disciplines can contribute to mitigating risk by putting the client first rather than their own motives. The average quantity surveyor, valuer, or building surveyor can contribute by adhering to high professional standards to avoid exposing their clients to risk. There is a need for better direction and thought-leadership to spread best practice in this area, and RICS professionals are perfectly placed to be a driving force behind that.
Our clients pay us to take risks on their behalf. These days, a risk-free investment is also a return-free investment. You have to aim for a satisfactory, risk-adjusted return. In this uncertain world, the crucial factor to avoid is mispricing risk, which leads you to think that you’re safe when you’re not.
