Luxembourg: How Risk Management Drives AIFs – Spotlight On Real Estate Funds

Last Updated: 8 June 2017
Article by Eugen Keller

Most Read Contributor in Luxembourg, July 2019

The financial crisis of 2008 has highlighted the importance of thorough risk management processes, especially in the real estate sector. For too long, risk management of real estate funds has been purely a qualitative exercise, owing to lacking data and lacking methods. As risks have become more and more complex and interrelated, this approach has reached its boundaries... while the risks have not reached theirs.

Besides portfolio management, risk management is the core business function of alternative investment fund managers (AIFMs). In this respect one of the main objectives of an AIFM is to establish and maintain a permanent risk management function as a central component of a sound internal control system. Such a system must, among other duties, have effective risk management policies and procedures in order to identify, measure, manage and monitor, on an ongoing basis, all the risks relevant to each AIF investment strategy and that each AIF is or may be exposed to.

AIFMD rules

The AIFMD requires fund managers to "put in place such risk measurement arrangements, processes and techniques as are necessary to ensure that the risks of positions taken and their contribution to the overall risk profile are accurately measured on the basis of sound and reliable data" (Article 45, Commission Delegated Regulation (EU) No 231/2013).

The AIFMD sets out the following principles and requirements (among others) for an AIFMD-compliant risk management function:

  • identification and risk profiling
  • a risk management policy with procedures that enable the AIFM to assess each of his/her AIFs' exposure to market, liquidity and counterparty risks, as well as to all other relevant risks, including operational risks, that may be material
  • calculation of leverage and other risk measures
  • accurate measurement, on the basis of sound and reliable data, of the risk of (single) positions taken and their contribution to the overall risk profile
  • establishment and implementation of quantitative risk limits aligned to risk profile and strategy and covering, at least, market, credit, liquidity, counterparty and operational risks
  • monitoring and controlling of the adequacy and effectiveness of the risk management policy and related arrangements, processes and techniques
  • implementation and documentation, by the AIFM, of appropriate liquidity management systems that monitor and manage the AIF's liquidity obligations, taking into consideration both assets and liabilities
  • periodic stress tests and scenario analyses that address risks arising from potential changes in market conditions that might adversely affect the AIF
  • reporting

Evaluating market value

Before setting up an adequate risk management approach it is necessary to understand the valuation techniques used for real estate property. In order to complete our own understanding, we set out to research in depth what is already available on the market regarding real estate risk measures. We analysed how the value of real estate is assessed, finding that within the valuation reports made available by fund management companies a few valuation methodologies are used. The large majority employed the Gross Rental Method (GRM), a standard procedure for calculating market value. Its most important factors are the object's year of construction and the discount rate used to determine the multiplier of the annual rent income. The computation of the market value is quite unpretentious and tends to include subjective additions or subtractions based on qualitative factors. The general idea behind this method is a simplified Discounted Cash Flow (DCF) analysis that assigns a value to an object equal to the income it is expected to generate in the future.

Knowing this, we have developed our own methodology for evaluating market value and associated risk of a real estate portfolio that allows for a less deterministic, volatile cash flow stream. It is built upon a DCF analysis for each individual real estate object included in the fund's portfolio, but runs on an adjusted GRM approach.

Incorporating uncertainty into real estate valuation not only provides different results over deterministic models, but also brings a new perspective on real estate valuation and risk measurement. Monte Carlo simulations are appropriate for modelling the value of real estate objects, as they are capable of handling a variety of changeable parameters. Based on the calculations, a variety of risk measures like Value-at-Risk (VaR), Cash Flow-at-Risk (CaR), average yield returns or sensitivity analysis can be derived and presented in easy-to-understand risk reports. This risk reporting will aid decision processes surrounding investment or divestment in real estate property.

We have ultimately taken these techniques and incorporated them into our RE Risk Tool. Our aim was to develop a procedure which can give a quantitative indicator of the risks attached to a real estate portfolio. Going further we will combine already developed techniques with innovative data and analytics methods in order to bring risk management approaches to the next level. Details are coming soon.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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