proactive
captial markets
Managing Risk in a Cyclical Business
Building a strong risk
management practice and
integrating it throughout
a business can help
businesses survive and
thrive in the long term.
138 U r b a n La ND J u ly 2 0 0 8
In the “easy money” environ-
ment of the first half of 2007, profits
could be had from rising real estate
prices, as an ocean of liquidity lifted
all ventures. Now that the tide of
liquidity has receded, dangers are
much closer to the surface. The
credit crunch that began last August
highlighted the strengths and weak-
nesses of risk management in the
commercial real estate industry.
Since then, many investors and
lending institutions have encountered
financial difficulties, in part because
of weak and ineffective risk manage-
ment practices. At many companies,
the problems were exacerbated by
risk management groups with little
real authority or that labored under
inappropriate reporting structures. At
some firms, risk managers reported
to, and were overridden by, business
leaders who wanted to close deals.
The traditional objection to risk
management is that it is “the art of
getting to ‘no.’ ” Proper risk man-
agement helps create sustainable
deals that can turn a profit for all
parties involved. Risk management
is truly put to the test in a declin-
ing real estate market, where the
best outcomes are often things
that don’t happen.
A primary goal of any risk manage-
ment function should be to provide a
rigorous and consistent process that
drives long-term business growth.
Risk management should proactively
communicate the standards and
guidelines for deals that a company
wants to attract and pursue.
In commercial real estate, a
thorough risk management process
often starts with a top-down view
of the marketplace. An analysis of
regional and national economic
forecasts can often set the overall
context in which lending and invest-
ing decisions are made.
On a micro level, each potential
property deal needs careful scrutiny.
J ay n e L . D ay
This bottom-up assessment needs
to be as exhaustive as is practical,
covering the actual and potential
risks associated with environmental,
structural, and insurance issues.
In addition, the risk management
function should conduct a credit
evaluation of customers, borrowers,
co-investors, primary tenants, and
all other parties with a financial role
in the transaction.
The results of these evaluations
can then be factored into the critical
function of determining sustain-
able income for a property and its
competitive position within a local
market. Consistency in application of
principles in determining a fully vetted
property valuation forms the basis of
any intelligent investment decision.
Finally, risk management needs to
take a step back and look at all of a
company’s holdings to avoid over-
exposure to any one particular city,
asset class, or economic sector.
One of the keys to a successful
risk management program is open
communication with the internal
deal team—origination, underwriting,
and asset management—as well as
with the customer. Open dialogue
can provide clarity on market risk for
all the participants involved—and
this can help the players understand
the individual transaction better, and
form realistic expectations for time-
tables and deal outcomes.
In turbulent economic times, a
strong risk management discipline
provides a basis for making defen-
sive decisions. For example, there
were relatively few trans­actions
during the first half of the year
because significant uncertainties
existed in the markets. At that stage
of a market cycle, sellers often will
not discount heavily enough to
compensate for the market uncer-
tainty. Only when a seller faces
distress—as in a defaulted loan—
can opportunities arise. In general,
making investment decisions in
a falling market is extremely chal-
lenging because the information
one has is never sufficient. Rapidly
falling market occupancy, which
typically precedes rent declines, is
clearly a red flag for investment. Yet,
it is hard to know whether values
will fall another 10 percent, 20 per-
cent, or even more. In times such
as these, it is best to seek stability
in markets that investors know well.
If one’s investment horizon is
longer than the anticipated down-
turn, it is easier to identify and
seize opportunities; significant
profits can be made by those who
dare to buy when no one else
does. Though it is impossible to
“time” the bottom of the cycle, the
traditional signs that a downturn
has ended include stability in occu-
pancy rates and rental rates for two
quarters. On a macro level, another
important indicator is when national
employment levels stop falling.
Striking a deal for a good
property at the right price with a
customer who has real estate expe-
rience and liquidity does not mean
that all risks have been covered.
Monitoring the many remaining
risks is also part of the responsibil-
ity. Three risks merit a closer look:
l Concentration risk. Having a
high proportion of properties in a
single geographic market or a single
asset class is a risk that is hard to
protect against. Also, having a high
percentage of a portfolio in a single
asset also presents problems. For
example, many investors have a
bias for large trophy buildings,
which hold their value for the most
part through cycles. However, to
make an error on a very large build-
ing versus many smaller ones can
really devastate a portfolio.
l Industry concentration. The
assumption is that a portfolio is
adequately diversified if it is split
between, say, Boston and San Fran-
cisco. But because both markets
are driven by the financial services
industry, this is really not the case.
Many similar pairings of different
markets are affected by the same
external factors.
l Green risk. What risk could
“green” buildings pose? The risk
may be the opportunity cost if a
building is the last to go green in
a market. Going forward, the more
green structures there are, the less
competitive nongreen buildings
will be. Green buildings may carry
a rental premium if they allow ten-
ants to save on operating costs
over time. The premium may also
be partially attributable to the
perception that they are healthier
places to work. When a cost-benefit
analysis of being green is taken into
account, a lot depends on what is
going on in a particular market.
One of the most important and
rewarding aspects of risk manage-
ment is its growing acceptance in
nearly every industry as a critical
business function—despite the dif-
ficulty of getting it right. As is true
of all investment professionals, the
best risk leaders are those who
have seen the downside, experi-
enced a full market cycle, and know
why things go wrong.
Risk is also a great place to begin
a career in real estate and leads
naturally to originations, business
development, and asset manage-
ment. That is because it teaches how
to underwrite a property and value
it, how to conduct a site inspection,
how to build financial models, and
how to do in-depth analysis.
Building a strong risk manage-
ment practice and integrating it
throughout a business will help
investors survive and thrive in the
long term. In today’s uncertain eco-
nomic times, having a viable risk
management function can provide a
competitive advantage. UL

Jayne L. Day is the senior vice president,

chief risk officer at GE Real Estate.

J u ly 2 0 0 8 U r b a n La n D 139