“Top business risks in real estate” by Jessie D. Cabaluna (November 15, 2010)

SUITS THE C-SUITE By Jessie D. Cabaluna
Business World (11/15/2010)

Real estate markets continue to recover from the global financial crisis. Many firms are progressing in streamlining operations and managing capital.

However, companies should still prepare for emerging risks that could undermine their reputation and competitive position. These risks may cause outright losses for a company and dramatic changes for the economy.

The top 10 business risks identified in The Ernst & Young Business Risk Report 2010 have changed and will continue to change the way real estate companies do business. In the local context, we see the following significant risks that real estate firms need to guard against so that they can best structure, implement and improve their risk management and monitoring processes.

Cyclical nature of the industry

A top risk that real estate companies face is the cyclical nature of the industry.

A robust economy is usually characterized by low interest rates, high levels of foreign inflows and remittances from overseas contract workers, and low inflation rates. With inexpensive financing readily available and families having more disposable income, demand for residential properties and retail spending go up. Businesses typically engage in expansion activities which trigger increased demand for office, commercial and industrial spaces.

The high demand for real estate fuels higher property values, and rental rates encourage real estate companies to invest further and develop new projects. In periods of economic growth, realty companies can embark simultaneously on several property developments since borrowing from financial institutions is relatively cheaper and readily accessible.

However, a heated economy cannot go on forever and will, at some point, slow down, causing the “bubble” to burst. Sales of residential properties will significantly drop as families move away from capital spending to prioritize basic needs. Office buildings will have more vacancies as companies scale down their operations to focus on their core competencies. The industry may again find itself in the midst of a supply glut, saddled with real estate inventories with decreasing values.

Highly-leveraged real estate companies are at high risk of suffering from credit shocks as their debts mature and refinancing becomes uncertain. For companies experiencing a credit crunch, the situation could worsen to the point where they are forced to abandon their ongoing projects and allow the banks to foreclose their mortgages. For those that are able to manage their liquidity issues, they may cut down on their existing projects and postpone plans for future developments.

This cycle is nothing new to real estate companies. Thus, they must exercise caution in times of economic prosperity and strengthen their balance sheets to enable them to withstand financial shocks during a downturn. While the cyclical nature of the industry is a risk to most companies, we also recognize that for others, it opens opportunities to further their industry position.

Increased competition

The industry is highly competitive with a handful of companies that cater to all income groups (high-end, middle-income and low-cost) and sectors (residential, commercial, retail, industrial and leisure); several medium-sized companies concentrating on selected sectors; and numerous companies focused on niche markets.

Real estate companies compete with each other primarily on the basis of location, affordability, quality, timely delivery and reputation. The inability of a company to compete effectively on these factors will result in unsold inventories which may have to be impaired and difficulties in sourcing funds as pre-selling activities are almost nil.

In addition, one of the primary drivers of a real estate company’s growth is the availability of a landbank suitable for future development. Companies encounter difficulties in locating sizeable parcels of land in locations that are suitable for development, particularly in Metro Manila and other urban areas. This limits growth as projects are fewer and may not be as attractive as those of competitors. We have seen the emergence of joint venture agreements between land owners and developers, participation in bidding for government properties and property swaps as some of the more common measures adopted by real estate companies to help boost their existing landbank.

Regulatory changes

Another key risk for the industry involves regulatory changes. Real estate companies are subject to environmental laws and regulations governing their construction and development activities.

A major change brought about by regulation is in the area of financial reporting introduced by (Philippine Interpretation) IFRIC-15, Agreements for the Construction of Real Estate, which becomes effective in 2012, based on the notice released by the Securities and Exchange Commission on Dec. 5, 2008. Currently, real estate companies which undertake pre-selling activities for both their horizontal and vertical projects use the percentage-of-completion method of accounting. This method enables companies to recognize real estate revenue and costs based on the percentage of completion of their respective projects.

However, under (Philippine Interpretation) IFRIC-15, it is unlikely that many projects will meet the necessary conditions for use of the percentage of completion method. This would result in a shift to the completed contract method which means that companies can recognize revenue only when the project is complete and the completed units are transferred to the buyers.

This change will have significant implications on a company’s financial accounting and reporting, management reporting systems, key performance measures, corporate finance, executive and employee compensation and investor relations. Real estate companies are advised to quantify the impact of the adoption of (Philippine Interpretation) IFRIC-15 and come up with an action plan on future activities to ensure compliance by 2012.

These three business risks are universal in their application and real estate companies can certainly gain much from understanding their implications. Real estate will always be a vital industry to a developing country such as ours and can contribute positively to the economy when they are managed as efficiently as possible.

(As of publication, Jessie D. Cabaluna is an Assurance Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.