As you probably know, running a real estate company involves a whole lot of financial risks. And if you don’t minimize those risks as much as possible, their consequences can be devastating. But how does one reduce financial risks? First, you need to identify and define them. When you’ve done that, you must ensure that your financial policy thoroughly describes the risks and how to manage them.
So, what financial risks do you need to take into consideration? As many risks go hand in hand with real estate financing, the main ones are the funding risk, interest rate risk, and liquidity risks, often described like this:
The funding risk can be divided into two parts, both equally connected to your funding. The first part is the risk of your company being unable to refund current loans or take new loans if needed. The second part is the risk of only being offered funding with unfavourable terms and conditions.
The risk of higher interest expenses if the interest rate increases and the risk of not being able to lower your interest rate if the market interest rate decreases if your loans, for example, have a fixed interest rate based on a higher price and a different market.
The liquidity risk refers to the risk of your company's inability to meet payment obligations due to insufficient liquid funds for planned or unforeseeable costs. Thus, the liquidity risk is highly connected to the funding risk, as how you manage this risk directly impacts the margins for managing your funding.
Once you have identified and clarified the financial risks in your finance policy, it’s time to dive into guidelines. To avoid circumstantial limitations that may be hard to fulfil, you should base each guideline on a defined risk. Remember, your guidelines are there to help you, not hinder you.
Use your guidelines to clearly define your level of risk based on a risk level your company can handle. To determine what level that is, you need to stress test and look at how different scenarios with higher interest rates and credit margins would impact your organization’s risks and results.
The limitations defined in your policy should also align with your daily operations. So, don’t forget your systems and accounting routines.
Let’s look at an example to make things a bit clearer. Below, we’ll show you how to define interest rate risks and related guidelines.
The risk of increasing interest expenses due to a higher market interest rate.
This risk impacts the part of your debt portfolio with a variable interest rate and debts that need to be restructured soon and, therefore, might get a higher interest rate.
One way to limit this risk may look like this:
The part of your portfolio with an interest rate due within a year should not stand for more than 40 % of your portfolio.
The risk of not getting a lower interest rate if the market interest rate drops, because you fixed your interest rates when the market price was higher.
The best way to deal with this type of risk is by spreading out the portfolio’s interest rate. Combine this risk with a guideline explaining how long the portfolio’s fixed interest rate should be. By distributing your interest rates, you avoid having a debt portfolio where everything, or at least significant parts, expire simultaneously or within a short time frame.
As mentioned above, it is essential that everything you define in your policy also works practically. Make sure not to put too high demands on spreading your interest rate costs. This might make it hard to follow the guideline and cause expensive transactions when the debt portfolio changes and you have to adjust the changes according to your policies.
A principle for how to reduce this risk might look like this:
The debt portfolio should have a good spread on the end date of its interest rates, with the average being within 2 to 5 years.
It is good if the guideline involves the average fixed interest rate period and the maximum end dates for interest rates within a year. With this in place, you have an excellent tool to establish how an increased or decreased market interest rate would affect your interest rate costs. In other words, it’s a strategic tool that your company’s board and finance department can use to define the proper risk levels for your company’s interest rate costs.
Other examples of mandates that you may include in the guidelines for how to manage the interest rate risk:
If you want to, you can define and manage the funding and liquidity risk like we have now done with the interest rate risk (and other financial risks that your company may be facing as well).
The mandates established in your financial policy need to be monitored and reported regularly. How frequently depends on the size of your company and variations in your debt portfolio. It is also essential to evaluate each mandate every year. Doing so can ensure they stay up-to-date and applicable to the market and your financial situation.
As both the market and your company’s financial situation may change, it is good to continuously evaluate whether current hedges align with the financial policy that you’ve established – and to ensure that your policy still serves its purpose and helps your company reach its financial targets.
To put the cherry on top of it all, you must regularly report all numbers and figures linked to your risk management. One way to simplify this process is to use a digital Treasury Management System such as Nordkap.
Using our Treasury Management System (TMS), you quickly access all numbers and figures needed for reporting directly in your portfolio. You’ll find tables and charts that show key numbers such as next year’s capital and interest decay, fixed interest rates, interest rate swaps, and capital durations, separating the risk of lending money from the cost risk within the funding.
Are you curious about how we can help you improve your company’s risk management or want to dive deeper into financial risk management? Reach out to our experts; they’d love to help you!
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