# Risk Framework

## How it works

Each property (or group of properties) is assigned a risk rating that helps convey our assessment of the risk of a loss to investors

The assigned risk ratings are the following:-

- Low
- Low-medium
- Medium
- Medium-high
- High

The basic premise is that for a loss to lenders to occur the following events have to happen:-

- The existing rental counterparty needs to default on the lease or the lease ends and they do not want to renew
- We can’t find another rental counterparty to enter into a lease on roughly equivalent (or better) terms
- We sell (under instructions from the lenders) for an amount that, after fees, is less than the price they paid for the loan (we refer to this as a capital loss)

It is clear that the price lenders pay for the loan is a key factor when it comes to assessing the chances of a loss and consequently this is a significant contributor to our risk assessment.

There is also risk of a loss if a rental counterparty stops paying rent for a period which we can not recover before the property is repossessed (we refer to this as a rental loss). Finally there is a risk of a loss if development work is undertaken that runs into problems that result in additional costs in excess of the amount budgeted(we refer to this as development loss).

Ratings are determined by way of a defined formula depending on a set of qualitative and quantitative inputs which are set out below:-

## Quantitative inputs

- Purchase price of the property
- The change in the Land Registry House Price Index since the purchase date for the property type in the local authority area of the property
- The current net price of the property on the Exchange
- Remaining Contingency fund
- Any rent deposit that is held
- Sunk costs relating to the property
- Expected fees/costs if the property is sold
- Time left on the lease
- Time to the next break clause
- The existence of any armageddon clauses

## Qualitative inputs (Risk factors)

- Rental counterparty credit risk

An assessment of the credit worthiness of the rental counterparty. Ie how likely they would be to break the lease - Lease renewal likelihood

How likely we assess the rental counterparty is to renew the lease - Ease of replacement of rental counterparty

Our assessment of how easy it would be to find a new counterparty on similar terms to lease the property - Ease of sale of property adjustment

Our assessment of how easy it would be to sell the property at a fair market value. Specialist property is considered harder to find a buyer - Development risk

How much work is scheduled to be undertaken on the property

The qualitative inputs are all assessed by Assetz Exchange and we refer to them as Risk factors. They are set with reference to the following criteria and are displayed in the property details section of each loan. We have agreed to take a cautious approach when assessing these factors.

These Risk factors then determine a series of Risk scores which have been set by Assetz Exchange in the following Risk grids.

The quantitative and qualitative inputs are used to produce estimates of the expected capital loss if a property had to be sold now and also an estimate of the rental loss if a rental counterparty was to stop paying and we had to take legal action to repossess the property.

We then adjust the capital loss and rental loss by what we call ‘Scaling scores’. These are calculated using the Risk scores, with the aim being to take into account the likelihood of the estimated loss ever coming to pass. This produces the Scaled capital loss and Scaled rental loss.

Finally the scaled losses are converted into coefficients that produce the ultimate Risk rating.

## Capital loss

The expected capital loss (if any) if a property was to be sold now is calculated as follows (using example figures):-

Property purchase price/RICS value | 160,000 | |

HPI% change | (5.8%) | |

HPI adjusted purchase price | 150,720 | |

Current net price on the Exchange | (150,000) | |

Sunk costs | (14,463) | |

Expected sales fees | (5,825) | |

Ease of sale adjustment | (3,016) | |

Total fees/costs | (23,304) | |

Estimate of capital loss if property sold now | (22,584) |

The original purchase price of the property is adjusted by the move in the Land Registry House Price Index for the property type in the local authority of the property and compared to the current net price on the Exchange. Off this we deduct:-

- ‘Sunk costs’, which are defined as additional loan money that has been spent on things that would not be recovered on sale, such as stamp duty, the loan arrangement fee, legal fees and bills.
- ‘Expected sales fees’ which are currently set as £1,000 in legal fees plus 3.2% of the forecast selling price of the property. This is made up of the 2% Assetz Exchange sales fee and 1.2% estate agent fee.
- ‘Ease of sale adjustment’ is an adjustment made to reflect the liquidity of the type of property. A property we deem harder to sell we make a larger adjustment.

This results in an estimate of the capital loss if the property is sold now.

## Scaled capital loss

We then take the estimate of capital loss and adjust it by what we call a Combined scaling score to produce a Scaled capital loss. This is done to produce a scaled figure that takes into account the likelihood of the estimated loss ever coming to pass.

The Combined scaling score is calculated as follows:-

Combined scaling score = (the time to break score + rental counterparty credit score + armageddon score) * ease of replacement of tenants score

The rationale behind the calculation is that we are assessing the chance that the current lease ends (either naturally, by a break or armageddon clause being exercised or by a counterparty defaulting) but discounting it by our assessment of the chances of finding a new counterparty on similar terms as the existing lease.

The Scaled capital loss is then calculated by multiplying this Combined scaling score by the expected Capital loss.

It is important to note that the resulting scaled capital loss is not a forecast of the estimated loss but simply a way of quantifying a potential loss in a way that allows us to translate it into an ultimate risk rating.

Continuing the above example, if the property has the following risk scores:-

Time to break score | = 27% |

Rental counterparty score | = 2% |

Armageddon score | = 0% |

Ease replacement tenants | = 90% |

Using the above formula we get a Combined Scaling Score of (27% + 2% + 0%) * 90% = 26%.

The Scaled capital loss is therefore 26% * 22,584 = £5,872

## Rental loss

The estimate of rental loss is a cautious view taken that legal action will be required to repossess the property and the time taken to do so is currently set at 12 months. We also assume that we can not recover any of the rent due during this period, which hopefully would not be the case. The estimate of rental loss is therefore calculated as property net yield * gross price on the Exchange.

So, in our example, if the current gross price is £173,183 and the current yield is 6.8%.

This means the estimate of rental loss is 173,183 * 6.8% = £11,776

## Scaled rental loss

We then multiply the Rental counterparty credit score by the estimated Rental loss to produce the Scaled rental loss.

Again this is simply a way of quantifying a potential loss in a way that allows us to translate it into an ultimate risk rating.

Continuing our example, the Rental counterparty credit score is 2% so we get a Scaled rental loss of 2% * 11,776 = £235

## Scaling coefficients

We then take the scaled capital loss and scaled rental loss and convert them into a coefficient that when summed with the Dev risk coefficient produces the Scaled total coefficient which is input into the Risk rating risk grid to produce the ultimate risk rating.

## Scaled capital coefficient

The Scaled capital loss divided by the current gross price of the property, expressed as a percentage.

In our example this gives, 5,872 / 173,183 = 3.39%

## Scaled rental coefficient

The Scaled rental loss divided by the current gross price of the property, expressed as a percentage.

In our example this gives, 235 / 173,183 = 0.14%

## Dev risk coefficient

The Dev coefficient is simply the risk score corresponding to the assessed dev risk factor taken directly from the risk grid.

Assume for our example the Dev risk factor is 2 (a reasonable level of mainly cosmetic works required) which gives a Dev risk coefficient of 2% (from the risk grid)

## Scaled total coefficient

The Scaled total coefficient is the sum of the above three coefficients.

Scaled total coefficient = Scaled capital coefficient + Scaled rental coefficient + Dev risk coefficient

## Risk rating

Finally, the risk rating for each property is calculated by plugging the Scaled total coefficient into the risk rating grid.

So in our example we have the following coefficients:-

Scaled capital coefficient | = 3.39% |

Scaled rental coefficient | = 0.14% |

Dev risk coefficient | = 2.0% |

Then the Scaled total coefficient will be 5.53%.

Plugging this into the risk rating grid gives a Risk rating of Low-Medium

from | to | rating |

0% | 3% | LOW |

3% | 7% | LOW-MEDIUM |

7% | 12% | MEDIUM |

12% | 15% | MEDIUM-HIGH |

15% | HIGH |

## Reviews

We endeavour to review all settings every 6 months but also whenever anything meaningful happens to either a counterparty or to a property. Any significant changes in quantitative or qualitative data will be communicated to investors by way of an update.