Risk Management in the ‘Long Top’ of the Recovery
NOTE TO READERS: This brief, authored by EDR Insight’s Dianne Crocker, was published in Commercial Real Estate Direct’s Mid-Year 2016 edition and is reprinted below with permission from the publisher.
The good news is that 2015 was the best year for commercial real estate since the downturn. But the first half of this year was not so good. Disparate forces are pulling the market in different directions, and that has important implications for how property risk is managed.
Transactions Trend Downward, Fewer Portfolios
Commercial real estate deal volumes have been trending downward in recent quarters, in stark contrast to the double-digit growth rates of the past few years. April sales of large commercial properties totaled $22 billion, down a significant 34 percent from a year earlier. The slowdown is largely attributable to a pronounced decline in large portfolio deals, which peaked in February 2015. In addition, the low interest rate environment that the market enjoyed for the past several years is slowly changing. Property prices that skyrocketed 93 percent from their 2010 low point are now plateauing—and even falling in certain areas. Much of the distress that characterized the first few years after the recession has now been addressed. So property “bargains” are now few and far between. With so much capital looking for a home in commercial real estate, investors are broadening their targets to include more options, such as smaller properties, those valued at between $10 million to $25 million, smaller metros where there’s less competition, and less desirable properties. For example, developers are targeting older assets for renovation, redevelopment or conversion projects. Out of a necessity to place capital, coupled with limited options, the market is embracing older space with a fervor it hasn’t seen in a long time. Particularly in urban areas, clean properties are in short supply, so developers are leveraging opportunities for infill development and conversion projects, using underutilized land or historic buildings for redevelopment.
Banks Tighten Reins on Borrowed Capital
Just as the environment for choice commercial properties is competitive, there is also strong competition among lending sources to originate new loans. Bank balance sheets swelled with commercial real estate debt in recent years, and regulators took notice, vowing more scrutiny on underwriting practices by banks, particularly those that increased their commercial real estate exposure.
This warning came in response to climbing loan levels as well as reports that banks were easing underwriting. Also impacting lending for commercial properties are the risk retention requirements in the CMBS sector, and more regulatory pressure related to Basel III requirements aimed at “high volatility” loans like those that fund construction projects.
Due to more intense regulatory scrutiny and market forces, lending was off to a wobbly start this year, and banks exhibited tighter underwriting as the market adjusted to new regulatory pressures. The riskiest deals, such as new construction, are having a harder time finding financing. Lenders in 2016 are also more cautious in gateway markets with elevated supply, and energy-centric markets like Houston, Dallas, North Dakota and southern Ohio.
New Lens of Risk Management
Recent market trends are contributing to the tonal shift to a less sanguine forecast, placing risk management in a new light. Property prices are no longer on a guaranteed upward trajectory and for investors, this is probably the most important change of late. If prices are no longer increasing as quickly, and there is no guarantee of higher prices down the road, does the property’s condition support the asking price? Are there environmental issues that could complicate development plans? At this later stage in the real estate cycle, when forecasters are starting to predict the next recession, investors are even more selective in view of an expectation of lower returns in the future.
And as developers turn their interest to older properties or sites in urban areas, property due diligence professionals are seeing more demand for their services to consider environmental risks. Finding good deals takes much more due diligence in a market where buyers and lenders are modeling the downside of every transaction as prices plateau and higher interest rates threaten to erode property value.
As property loans approach their maturities, old environmental reports are surfacing and being subjected to new scrutiny through today’s risk management lens. Environmental issues that would not have raised an eyebrow 10 years ago are today’s red flags. Issues like vapor intrusion risk are now standard practice in environmental due diligence, but were not typically addressed in due diligence before the recession.
EDR Insight’s ScoreKeeper model tracks environmental due diligence activity (measured in terms of the volume of Phase I environmental site assessments) for the U.S. market, regions, states and metros. Since due diligence is performed prior to a property transaction, Phase I ESA hot spots are a leading indicator of growing commercial real estate investment markets—much like the Architectural Billings Index is an economic indicator of future commercial real estate construction. As shown in the accompanying table, smaller secondary markets with strong growth profiles are seeing investor interest.
All Roads Point to Efficiency, Technology Solutions
Ask environmental due diligence consultants what their top challenges are in today’s market and chances are you’ll hear about the intense pressure for faster delivery of Phase I environmental site assessment reports. According to EDR Insight’s Benchmarking Survey of Environmental Professionals, nearly one-third (or 29 percent) indicated that speed is more important than price in winning projects. The squeeze on efficiency is due in part to pressures to complete commercial real estate deals quickly, and in part to technological advances that are improving the efficiency of all types of business processes.
Industry insiders are largely optimistic over the near term, pointing to solid property fundamentals, cautious underwriting and a relatively stable economy. Deal volume is expected to increase, albeit moderately, for another 18 months and then level off after 2017.
On the debt side, there continues to be strong liquidity and competition among capital sources, but also strong capital flows with commercial lending expected to see modest three percent growth this year with notable shifts by lender type. Amid a contracting market and intense pressures on efficiency, technology is poised to disrupt commercial real estate underwriting. Using technology and data in new ways to close property deals more quickly will surely be an important part of tomorrow’s market solutions.
The magazine also showcased the winners of this year’s EDR PRISM Awards, presented at May’s PRISM conference in Austin, TX.
FOR MORE INFORMATION
The full edition of CRE Direct’s Mid-Year Update includes insight from a number of industry leaders:
- Real Estate Markets Remain Healthy, But Warning Signals Are Flashing by Trepp’s Susan Persin
- Q1 Global Property Downturn: Three Different Declines, Not One by Real Capital Analytics’ Jim Costello
- Is Commercial Remodeling Taking the Place of New Construction? By BuildFax’s Holly Tachovsky
- The Survey Says: Commercial Real Estate Cycle Well Past Expansion Stage by Orest Mandzy
- Crocker’s article, Risk Management in the ‘Long Top’ of Recovery, begins on p. 10.