Risk is a key tool in the fund manager’s kit. The point is not to avoid it, but to get value for money in the trade-off between extra returns and higher risk. The better that managers understand sources of risk, as opposed to just its consequences, the better the trade-offs are likely to be.
In property, most people equated volatility with risk: prices told you everything about an asset, so volatility told you everything about risk. The possibility of risk existing outside the realms of price volatility was largely ignored.
July 2007 changed all that. Prices were volatile – falling – but often there were no market prices, as there was no liquidity. Banks’ excessive reliance on value when calculating risk, to the exclusion of other techniques, made matters worse and helped cause a dramatic reduction in credit, as bankers and property investors experienced the shortcomings of the “efficient” market hypothesis.
They discovered the hard way that the conventional capital asset pricing model no longer made sense and that real, systemic risks lurked in areas such as counterparty risk, leverage and agent/principal conflicts, as much as in price volatility. Risk comes from a variety of sources and shows an alarming ability to morph. For example, the risk of price volatility can be reduced by using derivatives, but only by increasing exposure to the possibility that the counterparty to the derivative will not honour the contract.
We need to understand the limitations of the capital asset pricing model and use it as a springboard to something more robust. This means considering risk latent in a portfolio that could prejudice its future returns, rather than just looking at past returns. Past returns tell you more about a manager than the properties, as many assets contributing to past returns will no longer be in the portfolio. Managers need information on risk before taking investment decisions, not afterwards.
There are two types of risk: fundamental risks, specific to individual assets, like rental downside, income delinquency, re-leasing and exit yield; and portfolio modulators, which pose a systemic risk for the whole portfolio, such as aggregated property leverage, asset or sector concentration rates, and derivatives or exchange rate hedging.
By taking these factors separately, portfolio managers can balance the mix of risks to best meet objectives. A manager good at stock selection may assemble a portfolio of fundamentally risky assets offering potentially higher returns, but use portfolio modulators to dampen overall risk – by keeping individual asset size small, building a cash cushion as risk increases, or using derivatives to hedge exposure. The risk in a fundamentally safe portfolio can also be turned up by using leverage.
The varied nature of assets can be exploited to build portfolios delivering a particular type of return: for example, by focusing on short leases or secondary tenants, or higher rates of expected rental growth. Arguably, the defining style of risk is more informative to investors than defining a portfolio purely in terms of expected returns, which are often just a function of leverage.
The relative importance of different sources of risk will vary through the cycle. Each of the three UK slumps between 1971 and 2008 featured the same sequence: yield upside shock (1974, 1989, 2007), followed by property taking longer to lease as demand contracted, then falls in real rents and finally an increase in income delinquency.
In the present cycle, increased leverage has amplified the impact of the initial yield shock. Rents are now falling while yields stabilise; the next phase will be increased income failures. It is still a fine judgement as to whether that source of risk is fully reflected in today’s values.
Risk is only a measurable sub-set of uncertainty. There are a range of factors whose effect on returns cannot be expressed even in terms of probabilities, such as regulatory responses to climate change. The challenge here is to better understand the issues and convert uncertainty into risk.