How Risky Is Property And Do You Know How To Work It Out?
One thing the pandemic reminded us is that human beings find it difficult to calculate risk.
Has the property industry learned from the pandemic and is it applying new approaches to risk on issues like climate change? The answer is yes, and not so much.
Data from both sides of the Atlantic showed — and still shows — that most people have a very poor grasp of risk.
Covid makes a good example. Americans are said to have “dramatically misunderstood” the risks they faced, particularly younger people. Yet Centers for Disease Control and Prevention data from November 2021 showed the risk of death for someone 75-84 years old is 150 times what it is for someone aged 18-29. But “150 times” is an idea we find hard to grasp, and so risk calculations get cloudy.
In the light of the COP26 climate summit, the property business is struggling to grasp the risks posed by sustainability and zero-carbon goals. The struggle fits into longstanding concerns that the concept of risk, and risk tolerance, is poorly understood in business.
So does the property industry habitually misprice the risk of something novel as higher than the cost of more-of-the-same? This is an error of judgment often known as the sunk-cost fallacy, and according to one engineering observer, the answer is “yes.”
“One of the major problems hindering progress in carbon reduction on the ground is the industry’s attitude to risk. For example, many developers are hesitant to use anything other than structural steel because the alternatives are perceived as being less safe — timber being a major case in point,” Webb Yates Engineers associate Liam Bryant said.
The desire for green design is good as far as it goes, but doesn’t get you very far; rather developers and investors need to think about their risk profile.
“Too many ideas and schemes are derailed due to perceived concerns around cost and programme 'risk', or more accurately, low-ambition and skills, rather than the real-life risks of flooding and climate disaster," Bryant said. "Better management of procurement and supply chain will easily mitigate the former, while the latter requires wholesale change to avoid catastrophic impacts. This is where timber goes back in.”
Vague concerns and handwringing about the 'risks' of timber often boil down to a general sense of unease about learning something 'new', resulting in a high contingency pot, making the proposal unviable, Bryant said.
An alternative way to handle a big risk is to break it down into smaller, more quantifiable risks. This is part of the approach at LGIM Real Assets, part of the Legal & General empire.
LGIM Real Assets head of ESG Shuen Chan said that a much more detailed analysis of flood risk is a good way to get a handle on climate risk.
“As part of developing a robust climate resilience strategy that supports our net zero roadmap, Real Assets has been working with a climate physical risk specialist to enhance our approach to incorporate forward-looking climate physical risk," Chan said. "The analysis indicates that flood risk poses the biggest current and future threat to our UK-based portfolio. This forward-looking risk assessment covers a time horizon out to 2030, 2050 and 2100.”
This enhanced approach is intended to provide more detail and greater accuracy. It all makes for more informed risk assessments.
Many of the risks to property in both the coronavirus pandemic and climate change come from potential building obsolesce. Not enough ventilation, too crowded, too energy inefficient: all potential causes of obsolesce.
According to Patron Capital Managing Director and senior partner Keith Breslauer the trick is to realise that everything is risky. Indeed, the entire point of property investment and development is to court risk. As a mountaineer and ski fan, risk is something for which Breslauer obviously has an appetite.
“By definition, I’m a risk-taker. You don’t make 18-20% returns by not taking risk," Breslauer said. "And any return over and above Treasury Gilts is by definition taking a risk. So property is a game of controlled risks, and they don’t always work out.
“The people who have the biggest accidents are often the people who had the most skill, because they think they know what they are doing and do not assess the risk properly. If you don’t believe you can lose, you can get destroyed.”
Breslauer recommends some meantime fixes. Try to think historically (ideally, be old enough to remember when things felt different), and remember that of the three risky points in any investment — buying, building up and exiting — getting the exit pricing right is the hardest, particularly if money is expensive.
Try to keep an eye on more than one property sector, he said. And remember things you don’t expect to be relevant can turn out to be enormously relevant, so big picture thinking is useful. Whilst you are at it, don’t borrow too much, because liquidity risk is invariably priced wrong.
The real risk issue is forgetting that a building is only worth its income stream. If the question is which is riskier, getting the reception area wrong or not doing enough on the embodied carbon in the steelwork, Breslauer’s answer is: the risk is not giving tenants what they want, because without them you have no income.
“Everything in the end depends on the tenants, on income flow. I can remember cases where the office lobbies were arguably over-specified, law firms refused to go into the building as tenants, so rent was impacted. Risk was to the income, not the lobby,” he said.
A recent report by accountancy giant EY revealed corporate leaders concerned that risk management tended to focus on downside mitigation (in other words, their risk tolerance was too low). They also worried that risk tended to be (wrongly) treated as a special subject, separate from all normal strategy discussions.
Risk is always with us. Property, Breslauer insists, is entirely complicit in risk. But the real risk may not be where you think it is.