Early Risk Warning System — a Use Case in Real Estate

An efficient risk management does have to include early risk warning applications in order to tackle with the inherent instability of investment markets and the insecurity coming along with risk decision making. Real estate investment markets are no exception to this.

This article is the second part in a series talking about the challenges of implementing early risk warning systems into the fabric of real estate corporations.

In the first part (references below) we talked about the importance of having a well running early risk warning system incorporated as well as the challenges of distinguishing between market signals and pure noise in the market.

In this part, we dive deeper and have a look at a real estate investor and its needs, not to say urgent necessities, to be covered by an early risk warning umbrella.

A word of caution: In this article we back our analysis with our professional opinion based on a general example and it is under no circumstances to be taken as investment/de-investment, financing or any other advice in specific cases. For analysis of your company please feel free to contact us.

Situation of the Real Estate Investor

But before we step in there, let’s see how the company is doing right now.

In short, the enterprise’s strategy is to invest in class-B buildings in 1st tier cities and class-A buildings in 2nd tier cities. Buildings in this case mean mainly office and partly retail, hotel and logistics.

As of 03/2022 the investor had 64 assets under management representing approximately 1 mln sqm with a market value of around EURO 1.4 blns. The assets are spread all over Germany. The company in a nutshell:

Profit & Loss

table by author

Rental income in the first quarter 2022 declined compared to the first quarter in 2021. Though, operating Cash Flow is still stable. Vacancy rate of the portfolio was always on a bit higher level but lately increased further to 11%.

image by author

The earnings situation is dominated by evaluation results. This becomes evident when looking at the results of the previous years:

table by author

Balance Sheet

table by author

At a first glance, the balance sheet also seems stable.

The assets are dominated of course by the real estate invested with a market value of around EURO 1.4 blns. The equity ratio is 35 %. This and the mainly longterm character of the liabilities reflect the longterm maturity of the assets.

It is worth noticing that 2/3 of the longterm liabilities are accounted for by a corporate bond with a term 2019/2024.

Early Risk Warning

As said before, in order to have a serious and -in front of all- an effective early risk warning system it has to be backed by well tuned predictive analytics tools.

Let’s take this use case and check where we would see leverage points for assigning early risk warning applications. By the way, these examples are not exhaustive.

B-class assets or 2nd-tier cities

The company’s strategy reflects markets and assets which might be more impacted by investment market volatility.

The potentially more accentuated “tail”-behaviour of market parameters (e.g. vacancy, investment yield), i.e. an expected heftier reaction on upcoming market circumstances, is to be examined and possible negative consequences are to be counterchecked with the corporation’s capability to offset them.

In this case,

  • market behaviour would have to be implemented in a quantitative risk model,
  • higher insecurity and new market circumstances should be taken into account while modelling,
  • potential market outcomes are to be simulated and quantified by their respective probabilities of materialising
  • and finally, those “weighted” market results should be connected to the risk positions of the portfolio in order to see the impact (still quantified by the chances of materialising in the future).

Here, a slight snapshot of the working of a model:

image by author

Two topics could be of special attention here:

  • Vacancy could be an issue as, beside the 11 % current vacancy rate, one single tenant accounts for by almost 15 % of the contractual rental income and another tenant with almost 5 % of the contractual rental income is under restructuring at this point.
  • Market value development: As learnt above, the earnings of the company are quite influenced by re-/de-evaluation results of the portfolio. So, it is worth examining what those market parameters which have a dominant impact on the market value could be up to in the future.

Funding

2/3 of the longterm liabilities are realised by a corporate bond facility with a term until October 2024. There are several issues here:

  • The corporate bond facility has three financial covenants incorporated. A predictive check of potential covenant defaults during the term would be advisable (if not done yet). After all, we are talking about the main funding facility in this entity.
  • Refinancing is due in October 2024. With this and without taking any further steps, the maturity ratio between assets and liabilities will turn heavily unfavourable at the next balance sheet date
  • Planning for refinancing on the other hand will open the question for future options which is not too easy a task given the current insecurities in the refinancing markets. This is to be modelled and simulated as well as to be connected to the risk positions of the portfolio (always weighted with respective probabilities of course).

ESG

The company holds B-class assets in its portfolio which might cause additional investments (probably without improving the income level) in order to hold up with increasing regulation on carbon emissions and better energy performance. One of the latest third party credit opinions (in connection with the company’s corporate bond rating) was elaborating on this issue.

This topic goes far beyond the usual predictive maintenance considerations and enters the area of structural market value considerations in the light of ESG regulations. In any case, this would fill up a whole article on its own and is beyond the scope of this one. So, we just mention it here.

Conclusion

Coming back to the balance sheet analysed in the beginning, we determined that as of 03/2022 the company had an equity ratio of 35 % based on a market value of the portfolio of EURO 1.4 blns.

In this case, a relative modest increase by 50 basis points in the average yield would cause a decrease in the equity ratio by 500 bps down to 30 %. Same effects you may see for those covenants fixed in the corporate bond framework. The reason for this fierce leverage effect is to be found in the yield level. More on this, you can find in one of our latest articles (references: see below).

And then compare the impact of these modest changes in market levels with the expectation that locations and assets in this category might have a much heftier reaction on market circumstances, i.e. a more accentuated “tail”-behaviour of market factors (which would have to be checked by predictive analytical tools). Seemingly stable and satisfying balance sheet positions could in this case deteriorate very fast.

But we are still speculating!

The behaviour of this market segment would have to be checked by data driven approaches and be implemented in the early risk warning umbrella of the company flexibly adjusted to the exact necessities of the respective corporation.

References

Risk Management in Booming Real Estate Markets by Christian Schitton, published on Medium/ December 3, 2021

Connecting Real Estate Markets and Portfolios with Predictive Analytics Tools by Christian Schitton, published on Medium and Analytics Vidhya/ June 3, 2021

Why Investment Volume Does Not Necessarily Guarantee Strong Markets by Christian Schitton, published in www.d-darks.com/blog / April 16, 2021

Real estate investor information, publicly available

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Christian Schitton

Combining Real Estate Investment & Finance expertise with advanced predictive analytics modelling. Created risk algorithms introducing data driven investing.