Risk Factors Characteristic of the Group

Risk of the management and human resources
 
The success of the Company’s investments will largely depend on decisions taken by persons in the Management Company who are responsible for management of the Company and on experience and capabilities of the said persons. There is no guarantee that the same persons will always remain responsible for management of the Company, however efforts will be used that activities of the Company would always be taken care of by properly qualified persons.
 
Transactions with related parties
 
There are quite a few transactions with related parties. Detailed information about such transactions is presented in Section 4.13 Related Party Transactions. Following applicable taxation legislation, transactions with related parties must be conducted at arm’s length. In spite of the fact that the Company’s Management uses all efforts in order to ensure the conformity with the above-mentioned standard, a theoretical taxation risk remains here, i.e. the risk that applicable taxes will be calculated according to prices applicable at arm’s length in case it is determined that certain transactions were conducted disregarding this principle, also the risk that relevant fines and default interest will be imposed. Besides, neither the Company nor its Subsidiaries have approved their transfer pricing policy.
 
Dependence on external financing
 
The Group’s cash inflows currently are sufficient to finance operating cash outflows and to pay monthly instalments of repayments and interests payments of bank borrowings. However, further development of the Group’s activities will require substantial amounts of capital to fund capital expenditures. For this reason, failure to secure adequate levels of external financing might limit the Group’s growth plans and place it at competitive disadvantage as compared to well-capitalized peers. Failure to obtain external financing may lead to forced sale of assets at unfavourable prices or even cause insolvency which may have a material adverse effect on the Group’s business, results of operation or financial condition and may destroy the shareholders’ value.
 
The Group is exposed to various risks due to long duration of real estate development projects
 
The core business of the Group is to ensure steady return from the current portfolio of assets. However, in order to achieve that the Group has to work on real estate development projects. The process of real estate development from the identification of the potential project to the disposal of the developed property usually lasts several years. Accordingly, the Group’s acquisition and development activities are subject to significant risks of non-completion and loss due to:
 
–       changing market conditions, which may result in diminished opportunities for acquiring desired properties, higher than expected development costs, lower than expected rental rates and lower than expected disposal prices;
–       competition from other market participants, which may diminish the Group’s opportunities for acquiring desired properties on favourable terms or at all;
–       the Group’s inability to acquire land at commercially acceptable terms or obtain detailed planning, including construction rights to the acquired land;
–       budget overruns and completion delays;
–       the Group’s potential inability to obtain financing on favourable terms or at all for individual projects or in the context of multiple projects being developed at the same time;
–       failure to meet the covenants in financing agreements, which may result in the lenders accelerating the repayments of loans under cross-default provisions;
–       defects in the legal title to land acquired by the Group, or defects in approvals or other authorisations relating to land held by the Group;
–       defects in acquired or developed properties, including latent defects in construction work that may not reveal themselves until many years after the Group has put a property in service and potential environmental damages;
–       potential significant amendments to the existing governmental rules and regulations or fiscal or monetary policies or introducing of a new governmental rules and regulations or fiscal or monetary policies applicable to the Group’s existing and future operations;
–       potential liabilities relating to the acquired land (incl. for example obligation to make certain investments and potential environmental damages), properties or entities owning properties for which the Group may have limited or no recourse;
–       property appraisers use assumptions, which are not stable and subject to changing market conditions which leads to fluctuations in property values.
 
Although many of these risks are beyond the control of the Group, any negative change in one or more of the factors listed above could adversely affect the business, results of operations and financial condition of the Group.
 
Dependence on small number of large projects
 
A small number of large projects in or near the capital cities of Lithuania and Latvia form substantially all of the Group’s development business. Concentration of large projects may increase the volatility of the Group’s results and increase its exposure to risks attaching to individual projects. Larger projects may also lead to proportionally larger cost overruns, which may negatively affect the Group’s operating margins. Geographic focus on capital cities of Lithuania and Latvia makes the Group vulnerable in case of a downturn in the property market in any of those cities.
 
Management believes that relatively few major projects in a limited number of geographic locations will continue representing a major part of the Group’s business in the foreseeable future. If the Group fails to achieve the expected margins or suffers losses on one or more of these large projects or if the property markets significantly deteriorate in Riga or Vilnius, this could have a material adverse effect on the Group’s results of operations or financial condition.
 
Inaccuracy of the forecasts
 
The Group’s profitability partly depends on its ability to forecast market prices, rents, property related costs, anticipated working capital needs, availability of financing, property values, etc. In connection with the Group’s acquisition of property for its development business, the Group bases the purchase prices it agrees for the property in part on projections of development costs, property values at the time of sale, future market rents, availability of financing and anticipated working capital etc. If the Group’s projections are inaccurate, it could experience lower profits, which could have a material adverse effect on its results of operations and financial condition.
 
Lack of insurance cover and specific reserves for indemnifying damages
 
The properties belonging to the Group could suffer physical damage caused by natural disasters, fire or other causes, resulting in losses which may be not fully compensated by insurance. The Group has obtained insurance coverage for its properties, which it believes to be in line with standard industry practice. The insurance covers, for example, losses and liability resulting from fire, break-in, diffusion, robbery, vandalism, pipe leakages, lightning, explosion, implementation of the extinguishing system storm, etc.
 
However, liability insurance aimed to cover damage caused to third parties is only some of the Group Subsidiaries’ insurance policies. A number of the Subsidiaries have valid business interruption insurance. However, insurance coverage is subject to limits and limitations and some risks (e.g. certain natural disasters and terrorist acts) are not covered by insurance for various reasons (e.g. because such risks are uninsurable or the cost of insurance is, according to Management’s belief, prohibitively high when compared to risk).
 
Even if the insurance is adequate to cover Group’s direct losses, the Group could be adversely affected by loss of earnings caused by or relating to its properties. The occurrence of any of the above referred harmful effects or insufficient insurance coverage may have a material adverse effect on the business, results of operations and financial conditions of the Group. This inter alia means that the Group could:
–       lose capital invested in the affected property as well as anticipated future lease income or sale proceeds from that property;
–       be held liable to repair damage caused by the event; and
–       remain liable for any debt or other financial obligation related to that property.
 
In addition to that the Group does not maintain separate funds nor does it set aside reserves for the above-referred types of events.
 
Risk related to lease agreements
 
The Group’s lease agreements may be divided into two categories: non-cancellable fixed-term lease agreements and cancellable lease agreements entered into for an unspecified term. For the cancellable lease and sublease agreements, tenants must notify the administrator 3–6 months in advance, if they wish to cancel the rent agreement and have to pay 3–12 months’ rent fee penalty for the cancellation. According to non-cancellable lease and sublease agreements tenants must pay the penalty equal to rentals receivable during the whole remaining lease period.
 
The Group seeks to use both types of agreements, depending on the market situation and the properties in question. Lease agreements entered into for an unspecified term involve nevertheless a risk that a large number of such agreements may be terminated within a short period of time. The Group aims at renewing the fixed term lease agreements flexibly in cooperation with its tenants. There are, however, no guarantees that the Group will be successful in this. In order to prevent tenants from terminating the lease agreements, the Group may also be forced to agree on the reduction of rent fees. The reduction of rent fees payable to the Group under a large number of lease agreements and/or concurrent termination of a large number of lease agreements could have a material adverse effect on the Group’s business, results of operations and financial condition.
 
Reliance on the administrator of the Company’s property
 
On 2 January 2013 the Company has entered into an agreement with a third party for property management and administration services on part of Company’s asset portfolio. The detailed list of buildings, administered, based on this agreement is provided in Section 4.20 Investment Restrictions. Under this agreement the third party, as an administrator of the property, is committed to increase Company’s value and maintain high quality of service for buildings’ tenants and employees. In case of change in administrative prices in the market, new contracts under less favourable conditions can be entered into with administrator, which may directly influence the increase in Company’s costs.
 
Interest rate risk
 
There is a risk that in case of fast recovery of the global economy or increase in inflation, central banks will increase interest rates and it will be more expensive to service loans in connection with the Company’s investments, therefore, the value of the Company’s investments can decrease. In order to avoid this risk, the Management Company shall seek that the Company would get most of its loans at fixed interest rates. If it seems necessary, the Company shall hedge against interest rate risk when entering into relevant transactions.
 
Furthermore, interest rate risk mainly includes loans with a variable interest rate. On 26 August 2014 the Company and Šiaulių Bankas AB entered into a credit agreement for EUR 15.35 million credit (on 29 January 2016 a credit was increased by EUR 4.5 million) with variable interest rate – 6 month EURIBOR and fixed margin. In addition to that, on 15 July 2015 the Subsidiary Dommo Biznesa Parks SIA and ABLV Bank AS entered into a credit agreement in an amount of 3 million with variable interest rate – 3 month EURIBOR and fixed margin. Rising interest rates will increase the Group’s debt service costs, which will reduce the return on investment. If considered necessary, the Group will manage interest rate risk by entering into financial derivatives’ contracts.
 
Leverage risk
 
Leverage risk is related to possible depreciation of real estate objects acquired with borrowed money. The bigger the leverage, the higher probability of this risk is. The level of borrowings of the Group was 42% of its investment property market value as of 30 June 2016 (47% as of 31 December 2015).
 
Credit risk
 
The Company has given and may have given loans to other companies, therefore, in case of deterioration of the financial condition of those companies, there is a risk that the Company will not get back all the loans granted by it.
 
Risk of spin-off from Invalda INVL AB
 
On 29 April 2014 the Company took over 30.9% of the assets, equity and liabilities of Invalda LT AB (currently, Invalda INVL AB). If certain obligations of Invalda INVL AB were not known at the time of the spin-off and for this reason were not distributed to all companies operating after the spin-off, all the companies operating after the spin-off will be liable for them jointly and severally. The liability of each of those companies for these obligations will be limited by the amount of the equity, assigned to each of them according to the terms of spin-off. Thus, there is a risk that if the obligations of Invalda INVL AB are not distributed, the Company will be liable for obligations of Invalda INVL AB, which according to the terms of spin-off are assigned to the Company. The Company does not have any information that the reorganisation of Invalda INVL AB was performed improperly and/or that some of the obligations of Invalda INVL AB are not distributed.
 
Reorganisation risk
 
The Company after the reorganisation – the Merger of Former Parent Company with the Company (previous name – Invalda nekilnojamojo turto fondasAB), which continues its activities after the Merger, took over all the assets, equity and liabilities of the Former Parent Company (for more information on the reorganisation please see Section 4.3 History and Development of the Group). For any and all the obligations of the Former Parent Company after the reorganisation, the Company took responsibility.
 
Liquidity risk
 
This is a risk to incur losses due to low liquidity of the market, when it becomes difficult to sell assets at the desired time at the desired price. In management of this risk, the Company will regularly monitor the real estate market, will get ready for the property sale process in advance, in this way reducing the liquidity risk. Acquiring Shares, the shareholders also assume the risk of securities liquidity – in case of a drop in demand for Shares or delisting them from the stock exchange, investors would find it difficult to sell them. In case of deterioration of the Company’s financial situation, the demand for Shares, as well as their price may decrease. Liquidity risk also covers the cash flow disruption risk incurred by the Company due to late payments and/or full default on monetary obligations by insolvent tenants.
 
Total investment risk
 
The value of the investment in real estate can vary in the short term, depending on the general economic conditions, rent and purchase prices of real estate, demand and supply fluctuations, etc. Investment in real estate should be carried out in the medium and long term, so that the investor could avoid short-term price fluctuations. Investing in real estate is related to higher than medium risks. Failure of investments of the Group or under other ill-affected circumstances (having been unable to pay for the creditors) can have a significant adverse effect on the Group’s performance and financial situation or in the worst case scenario bankruptcy proceedings may be initiated.
 
Investment diversification risk
 
This is a risk that one bad investment can have a significant effect on the results of the Company. In order to reduce this risk, the Company will have a sufficient number of different real estate objects in its portfolio, in this way maintaining the proper diversification level.
 
Tenants’ risk
 
The Company will seek to let real estate objects at as high prices as possible. Though currently the rent is paid in time (overdue obligations of tenants are very small and are not significant for activities of the Company), there is a risk that upon change (deterioration) of the economic situation the tenants will default on their obligations – this would have a negative impact on the profit and cash flows of the Company. In case of late performance of a large part of obligations, the ordinary business of the Company may be disrupted, it may be necessary to search for additional sources of financing, which may be not always available. The Company, in case of failure to earn planned income from lease or to maintain a high percentage of occupation of the buildings, can face the problem of costs that are not compensated by permanent tenants. This risk may manifest itself in case of big increase in the supply of rented premises and reduction in demand, drop in rental fees. In case of a failure to let the premises at planned prices or in planned scopes, also in case current tenants terminate their lease agreements, the income of the Company could decrease, whereas fixed costs would remain the same. Accordingly, the profit of the Company would decrease.
 
Risk of financial intermediaries
 
The Company will also incur risk by keeping funds in bank accounts or investing into short-term financial instruments. Currently, no short-term financial instruments are being acquired, excess funds are kept in bank accounts or are used to cover obligations of the Company.
 
Risk of insolvency of the Company
 
In case of realisation of one or several of the risks indicated in this Section, which would have a negative effect on the value and/or liquidity of investments of the Company, this can result in the Company’s solvency problems, when the Company will be incapable of fulfilling its obligations. In such a case, shareholders can lose all their funds invested into the Company.
 
Sub-lease agreement risk
 
In 2007 the Company has sold 5 real estate properties and entered into the operating lease agreement with the buyer until August 2017. For more information on this agreement please see Section 4.16 Material Contracts. All these properties are sub-leased to third parties. For the remaining part of the contract the Company is incurring about EUR 20,000 loss (future rent income from subleased premises minus contractual lease payments and estimates of maintenance and management expenses of leased premises) per month due to this sublease arrangement. This amount varies depending on the income from the sub-lease, property maintenance costs incurred and the rent fees paid.
 
The Group’s reputation may be damaged
 
The Group’s ability to attract purchasers of property, attract and retain tenants, raise the necessary financing for the development projects as well as retain personnel in its employment may suffer if the Group’s reputation is damaged. Matters affecting the Group’s reputation may include, among other things, the quality and safety of its premises and compliance with laws and regulations. Any damage to the Group’s reputation due to, for example, including but not limited to the aforementioned matters, may have a material adverse effect on the business, results of operations and financial condition of the Group.
 
Dependence on IT systems
 
The Group is dependent on a variety of 3rd party developed and used IT systems and web-based solutions for operations, including internal accounting and management information systems, handling of customer and tenant information, project designs and specifications, and general administrative functions. Failures or significant disruptions to the 3rd parties’ IT systems could prevent them from providing their services to the Group efficiently. Furthermore, should the 3rd parties experience a significant security breakdown or other disruption to their IT systems, sensitive information could be compromised and their operations could be disrupted which in turn could harm Group’s relationship with its customers and suppliers, or otherwise have a material adverse effect on the Group’s business, results of operations and financial condition.
 
Risk of valuation of the Company’s assets
 
The assets of the Company will be evaluated according to the main rules set in the Articles of Association and the Accounting Policy of the Management Company. Valuation of individual assets held by the Company shall be performed by two property appraisers, however such valuation of assets shall be only determining the value of the assets, which does not automatically mean the exact sale price of an investment held by the Company, which depends on many circumstances, for example, economic and other conditions, which cannot be controlled. Thus, the sale price of investments held by the Company can be higher or lower than the value of assets determined by a property appraiser.
 
Competition risk
 
The Company, investing into investment objects, will compete with other investors, including, without limitation, with other investment companies or real estate investment funds. Thus, there is a risk that competition with other investors will demand that the Company would conduct transactions at less favourable conditions than it would be possible in other cases.
 
Risk related to the duty to redeem shares of the Company
 
Legal acts provide for a duty of the Company in certain circumstances to redeem its Shares from the shareholders that requested such redemption (please see Articles of Association). Accordingly, if the Company becomes subject to the duty to offer to the shareholders redemption of its own Shares and if such a redemption is requested by the shareholders holding a significant number of Shares, the Company can be forced to sell its investments urgently, which can significantly reduce the return earned by the Company from sale of its investments. This risk is planned to be managed by means stipulated in the Articles of Association.

 

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