How real estate developers manage their risks?

Boris Agranovich

This article is part of the series "Popular Risk Management". The aim of the series is to describe the main risk management topics in simple, clear and concise language. To stay updated on the recent trends, please make sure to check out our Risk Management Show podcast on the major podcast apps or via the following link:

1. Introduction

Due to the current economic crisis caused by the sub-prime mortgages and the recent default of Dubai World, real estate has become a popular subject for debate. In this article I will describe the real estate development risks and their mitigation.

Real estate development consists of land assembly, development, financing, building and the lease or sale of residential, commercial and industrial property. Real estate development is a very dynamic process with a significant average duration.


Real Estate Types

First of all what types of real estate are there?

Real estate consists of the following types.

a) Retail: These are projects suitable for shopping purposes with modern outfitting, appropriate access and visibility and sufficient parking space. The occupiers will be tenants. Investors and, more exceptionally occupiers, will be purchasers.

b) Residential: This concerns the development of buildings suitable for family living on a long-term basis. The ultimate occupier will be a “resident”, however the ultimate investor can vary from owner-occupier to institutional investor.

c) Offices: Buildings that could be used for market standard office buildings. The buildings should normally be fitted for occupancy by multiple tenants.

d) Industrial/logistics: Industrial real estate building for multi or single-tenant purpose. The investors are the ultimate purchasers.

e) Mixed-use: This concerns projects being a combination of two or more of the above types.

f) Area development: This concerns complex long-term mixed-use developments, which are often undertaken in joint effort with public bodies.


2 Risks and risk-mitigating measures at the project level

Each type of Real Estate has its own risks. Below is a description of the risks that may occur in the Real Estate business, along with the mitigating measures.


Project Risks

The risks can be grouped in the following clusters:

a) Land value risk: land acquisition costs and the risk that the value of acquired land changes due to market circumstances.

b) Land exploitation risk: the risks mainly related to environmental issues.

c) Planning permit risk: the risk that no usable planning permit is received or that this process takes longer than expected. This risk also applies to other municipal approvals/permits, such as commercial licenses. Whether or not grants are obtained is also included in this risk.

d) Construction risk: this regards pricing, design, quality and possible delays.

e) Revenue risk: there are many factors that influence revenues. These include yields, rent levels, sales price levels, inflation and interest rate levels, demand and supply.

f) Duration risk: the duration is a consequence of other risks. It can impact interest costs, but can also cause other problems, such as claims from tenants if the agreed opening date of a shopping centre is not met. A delay could also mean that the project has to face adverse market circumstances.

g) Political risk: the risk that the project encounters problems due to a change in government, regulations, etc.

h) Partner risk: the risk that a partner in the project cannot meet its obligations or disagrees on the way forward.

i) Legal risk: this covers a broad area of topics: possible objections against changes in zoning, liability risks or contracts which have not been drawn up correctly. It also concerns the risk of not obtaining the required permits and the risks involved with buying existing companies to acquire land positions. Tax risk is also included in the legal risk.


Risk mitigating measures at project level

To mitigate the above mentioned risks the following mitigations can be highlighted:

a) Research is essential in assessing virtually all kinds of risks. Important research areas will include:

1) Forecast of yield development;

2) Allocation strategy;

3) Investor demand;

4) Occupiers and consumer demand: The research into partners (financial position and due diligence check) is also included under ‘research’ and should be satisfactory;

b) Phasing: By adequately phasing projects, the steps to be taken are smaller, with possible exits following each phase.

c) Contracts: Many risks can be mitigated by carefully drawn up contracts. It is therefore essential that the legal department is involved, either directly or indirectly by instructing local lawyers. Regarding construction risk it is crucial to use controlled pricing mechanisms when entering into construction contracts. Therefore, it is preferred to have a fixed price contract to the largest possible extent. Depending on the project, flexibility might be needed to achieve the best price possible or to allow for tenant demands, design changes etc. All projects need also to be insured in line with insurance policies. Furthermore, the quality of partner agreements (clauses on the decision process and exit possibilities) need to be highlighted.
Cost calculations: A development appraisal consists of assumptions which become more certain in the course of the project. The risk of surprises and wrong assumptions made during the process need to be mitigated by meticulous calculations. These will be made during the development process as the design will evolve toward final specifications and will have to take into account inflation levels, price increases as a result of increasing demand etc. Where necessary, these should be verified externally.

e) Pre-lease/-sales: In order to ‘test’ the market of end-users before entering into the commitment to actual starting of construction of a project, a certain rate of pre-letting or pre-selling is required. It’s also the ambition to enter other major commitments (a.o land purchase) conditional upon these market-tests. In addition to demonstrating the market appetite this will reduce the amount at risk as well, since pre-leasing/selling locks in part of the revenues.

f) Timing payments: in the case of costs it is preferred to pay as late as possible, whereas in the case of revenues it is preferred to receive these as early as possible.

Next to the obvious advantage of lower interest costs, this strategy provides control in case of possible disputes, relating to for example contracts.

Furthermore, it is preferable to keep the level of spending in the development phase to such a level that a real go/no-go decision before the start of the construction phase is still possible.


3 Risk-mitigating measures at the portfolio level

At the portfolio level there are a number of risk mitigating measures in place. These are the following:


Portfolio diversification

A Real Estate developer is often active in more than one country; the markets in these countries differ. Because the portfolio of the company is spread over several countries, segments and project sizes the portfolio is rather diversified. However, it is difficult to set up exact target portfolio diversification, since it is not possible to determine which diversification would create an optimal risk/return ratio.

In order to be able to manage the portfolio and diversification over countries and segments, regular reports are essential together with an outlook based on the existing pipeline.

Maximum Investment at Risk at the portfolio level

Current commitments minus secured revenues should never exceed pre-specified limits on amounts at the portfolio level.

Restrictions regarding strategic land positions

Strategic land positions concern land /buildings without sufficient rental income and not yet zoned for new development functions. At the portfolio level the following limits should be in place:

- the total investment in strategic land positions should not exceed a pre-specified limit on amounts.

- strategic land will only be purchased for the purpose of residential or retail development.

- the maximum tenure of strategic land positions is restricted in line with the pre-specified policy: for example, differentiation between mature and growth countries.

To diversify the risk the average tenure of holding the land for strategic purposes should be roughly spread over a pre-defined number of years which should be monitored via periodic reporting.


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Please send your comments to: info@globalriskconsult.comWritten by Boris Agranovich