Real Estate Risk Assessment

SustainableRealEstateMarketsRestoringConfidenceinFinancialMarkets

Peter Champness

MIPIM

PaM

Cannes

March 2011

improvingperformanceinbankingandrealestateinvestment

BackgroundtoRiskAssessmentinRealEstate(PaMModel)
Investors and financial market analysts require a more scientific approach to understanding holding risk, liquidity and volatility in RE Markets. The regulatory gap exposed by inadequate information on real estate risk has eroded prudent mortgage underwriting practice and hampered the effectiveness of monitoring by regulators and the role of Rating Agencies.

TEGoVA2003standard EuropeanPropertyFederation20032005report RICS2007report BasleII&BasleIII UNECE/REM (i) UNECEPolicyFrameworkforRealEstateMarkets Principle7 (Transparency/Valuation) (ii)FutureadvisoryworkREpropertyandmarketriskevaluationforREbackedfinancial products
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improvingperformanceinbankingandrealestateinvestment

Volatility acharacteristicofrealestatemarkets. Realestateinvestmentisdifferentiatedfromstockmarket investmentby:

o o o o o o Heterogeneityofassetsandplayers Illiquidity Largelotsizes Significantlygearing bankborrowing Cyclescharacterisedbyleadsandlagsduetosupplyconstraints Mediumtolongrunholdperiods Opacity limitedmarketdata

Lackoftransparencyandilliquiditycontributeto volatilityandundermineinvestorconfidence.
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improvingperformanceinbankingandrealestateinvestment

Howdowemanagerealestaterisk?
Indices,suchasIPD,trackhistoricmarketperformance. Valuationassessesspotmarketprices. Modernportfoliotheoryfacilitatesportfoliodiversification,concentration; moderatingsectorrisk. The quality of real estate as collateral for loans is recognised by credit risk scoring, loan to value ratios (LTV) and interest cover. Research; Identifying the demand and the supply pipeline and shifts in capital markets provides transparency and aids understanding of the dynamics of real estate markets.

AmorerobustprocessoffundamentalanalysisofREassetsis vitaltomoveriskmanagementoutoftheDarkAges.

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improvingperformanceinbankingandrealestateinvestment

ActiveREmarketsandeconomiesdependonbanklending RELendingisconstrainedbybalancesheetissues,regulatorygold plating,lackofinterbanklending&moribundsecuritisation (ABS)markets ReignitingthemarketforABSisessentialtofreeupbankbalancesheets toenablelending,facilitatingeconomicgrowth

Lookingahead,aselfsustainedrevivaloftheABSmarketrequiresfundamental changes.Itishightimetorisetothechallengesoftransparency,standardisationand productsimplicity.Thisiswheretheindustryhastostepupitseffortsinordertohelp decisivelyinrestoringconfidenceinthesecuritisationmarkets. JosManuelGonzlezPramooftheEuropeanCentralBank

Fundamentalrealestateanalysis(PaM)canenhanceconfidencein theperformanceofdebtandequityinvestmentinrealestateand derivativefinancialproducts

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improvingperformanceinbankingandrealestateinvestment

Potential scope of work REM-Real Estate Risk Assessment

PROBLEMOFRISKINREALESTATELENDING APPROACHTOREALESTATELENDINGRISK PROPERTYMARKETANDRISKRATINGSYSTEMS REVIEWOFVALUATIONSTANDARDS OUTLINEOFTEGOVAPROPERTYMARKETANDRISKRATINGSYSTEM PRACTICALAPPLICATIONOFPROPERTYMARKETANDRISKRATINGSYSTEMS REMRECOMMENDATIONSANDPOLICYOPTIONS

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improvingperformanceinbankingandrealestateinvestment

ExampleofthenewapproachtoriskinitiallypromulgatedbyTEGoVA PaM disastrous

PaM is a method of measuring the underlying quality of a property and very poor midterm marketability.
poor

10 9 8 7 6 5 4 3 2 1

PaM provides an analysis of the risks and potential inherent in a property or portfolio. Credit risk scoring is not specifically incorporated the focus is on the asset.

mediocre slightly below average average slightly above average good very good excellent

Itassessesfourkeypropertyfundamentals: iMarket iiLocation iiiProperty ivCashflow

PaM is complementary to Valuation. But Valuation sets out only what a typical purchaser would pay in the spot market on a specific valuation date. Valuation can be affected by transient market sentiment. It is no indicator of the medium and long term sales prospects of a property.
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improvingperformanceinbankingandrealestateinvestment

Property and Market Rating Model

1MarketEnvironment20%

disastrous very poor poor mediocre

10 9 8 7 6 5 4 3 2 1

Socioeconomic/demographic/realestatecycle
2Location30%

slightly below average average slightly above average

Suitability/standing/transportinfrastructure/facilities/environment
3Property20%

Construction/layout/sustainability/energyperformance
4Qualityofcashflow30% Tenantsituation/rental&valuegrowth/lettingprospects/vacancysituation/expenses

good very good excellent

OverallPropertyMarketRating110 Quality/marketability/sustainablevalue
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improvingperformanceinbankingandrealestateinvestment

RealEstateMarketRatingiscomparabletoRatingAgenciesCreditScores

Aaa to AA3 A1 to A3

Baa1 to Baa2

Baa3 to Ba1

Ba2 to Ba3`

B1

B2

B3 to Caa

Moody's

AAA to AA A+ to A-

BBB+ to BBB

BBB- to BB+

BB to BB-

B+

B- to C

S &P

excellent very good

good

above average

average

below average

poor/ special mention

very poor/ substandard

doubtful

loss

Internal Bank Ratings Property & Market Rating (PaM)

10

Excellent very good

good

slightly above average average

slightly below mediocre average

poor

very poor

disastrous

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improvingperformanceinbankingandrealestateinvestment

PaM Identifies:
UnderlyingAssetQuality/Sustainabilityofvalues RelativeVolatility similartoBetaratings Liquidityorrelativemarketability

Provides:
Enhancedtransparency

Enables:
Informedanalysisandportfoliodiversificationbyrisksegmentation(abottomup approachtorisk) Effectiveportfoliomanagementoptimisingfutureperformance Riskappraisal

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improvingperformanceinbankingandrealestateinvestment

HowPropertyandMarketRating addvalue? 1. Investors(DraftAIFMDirective

requiresRiskManagement)
1. 2. 3. 4. 5. Transactions PortfolioManagement Analysis Economic Environment Marketing Reporting

2. Banks
1. 2. 3. 4. 5. BasleIII Loanpricing Management Coveredbonds/securitisation Riskmanagementteamdialogue withpropertybankers Valuationcheck Consistency Riskpremiums Analysis Qualityofadvice

3. Valuers(KSWS3)
1. 2. 3. 4. 5.

Property Market

Risk

Asset

Cash Flow

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Property&MarketRating PaMSoftwareDevelopmentConcept Concept: Lowcost Userfriendly Quickandefficientinuse

o Developmentindiskformat(CDs) o FutureDevelopmentmaybewebbased

Economy

Property

Cash Flow

PaM

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improvingperformanceinbankingandrealestateinvestment

Contact
Peter Champness Itrium Limited Oakdene House Mayfield East Sussex TN20 6EJ United Kingdom + 44 (0) 759 7979 689 pchampness@itrium.co.uk

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