Recovery in Michigan’s Property Due Diligence Market Marches On

NOTE TO READERS: This article, authored by EDR Insight’s Dianne Crocker, appeared in the Fall 2015 quarterly newsletter of the Michigan Association of Environmental Professionals.

With the third quarter of 2015 now behind us, Michigan’s Phase I environmental site assessment market continues on its path to recovery along with the broader commercial real estate market. This article summarizes what the latest barometers tell us about the current state of the market and what makes Michigan’s environmental due diligence market unique.

More Property Deals, More Investors, More Capital

On the national front, the good news is the commercial real estate market today is bigger than it was in 2006. The key market indicators that impact environmental due diligence activity are trending in a positive direction, including:

  • Transaction activity continues to be the highlight of this recovery. The first half of 2015 was impressive, with solid growth in both large commercial property sales (up by a robust 36%) and small transactions (up by 14%). Despite a slow July/August, year-end 2015 transaction volume is expected to easily surpass last year’s.
  • Job growth, a strong driver of commercial real estate demand, is now back to prior peak levels, driving demand for office space, multifamily and retail.
  • Interest rates are still extremely low, fostering a favorable transactions environment.
  • New construction/development is at its highest point post-downturn.
  • Investors are more willing to accept additional risk, and are looking outside the safe gateway markets for returns, bringing new opportunities to secondary, and even tertiary metros.
  • The number of active buyers in commercial real estate has increased three-fold since 2009, and foreign investment is at an all-time high.

The environmental due diligence is not without its challenges, but consultants can take solace in the fact that the first three quarters of 2015 were very favorable and are expected to remain that way into the new year.

Banks Finally Playing Offense

The lending environment for commercial properties deserves special attention. At this stage of the market’s recovery, all of the major spigots of capital for property lending are open, and access to credit is widespread, especially for construction lending. After cleaning up their balance sheets in the years following the market downturn, financial institutions are playing offense again.

Many institutions, particularly regional banks, plan to grow their commercial real estate lending operations in an environment of intense competition among lending sources.

According to Steve Price, Principal and Vice President at PM Environmental, “I have met with several small- to medium-sized community banks over the last several months and most report lending volume is up. It is also promising to see that many smaller community banks that have been struggling to get out of the downturn malaise are now beginning to lend again. In the past, the refi-to-new purchase transaction ratio has run around 70/30. Now I have been hearing that new purchase transactions are up significantly, which reflects a growing confidence on the part of borrowers.”

In terms of loan type, construction and development lending is the fastest growing category of commercial real estate loans across banks of all asset sizes. Cranes are showing up again in cities that are finally seeing a pickup in employment, and developers are sufficiently comfortable with the pace of economic growth that projects once stalled during the downturn are getting underway again.

In terms of risk aversion, underwriting on commercial real estate loans remains markedly more prudent compared to 2006 and early 2007. Regulatory pressure to manage all types of risks, including environmental, has had an impact in terms of more institutions having formal policies and ensuring that they are being adhered to and documented consistently.

“Risk tolerance at the lender and purchaser level remains balanced,” according to Anthony Kashat, Principal, AKT Peerless, “and remains a priority for both parties.”

There are, however, anecdotal instances of lenders relaxing underwriting as lending ramps back up. “While I generally agree that risk tolerance has become more conservative since the downturn,” Price continued, “I am still hearing stories from bankers that have lost deals to other lenders that have fallen back to very lax underwriting, indicating that there are some who did not learn their lesson over the last several years.” Lending is picking up from a variety of sources, from commercial banks to insurance companies to real estate investment trusts, as well as credit unions. “I am also seeing more work from credit unions,” Price observed. “They are looking much harder at environmental risks these days. Many of the commercial underwriting departments within these organizations are being staffed with seasoned lenders who want to do the right thing and make sure risks are well understood.”

Another lending sector trend that offers a near-term opportunity to environmental consultants is the “Wall of Maturities” in the commercial mortgage market. Between now and 2017, more than $300 billion in commercial real estate loans will mature and need to be refinanced. For perspective, this volume of maturities represents more than 2.5 times the amount that matured from 2012 to 2014. Lenders view this wave of maturities as a solid opportunity to increase their volumes, and there seems to be no shortage of capital seeking to provide financing for solid real estate deals. The Phase I ESA market has already experienced a 2015 uptick in activity tied to loan maturities and, if interest rates rise, the market will see even higher demand as owners try to lock in rates. With the early maturities in this wave, it is worth noting that one-quarter of the total loans set to mature this year refinanced early and environmental consultants have been challenged to meet tight turnaround time demand on due diligence to support this activity. Many of the 2016 loan maturities are being refinanced in 2015, and barring a sudden spike in interest rates, many of the 2017 loan maturities will be refinanced in 2016, making this a very short-term opportunity for the due diligence market.

Michigan’s Phase I ESA Market

Although the U.S. Phase I environmental site assessment market has benefitted from a myriad of positive developments in the commercial real estate and lending sectors, growth rates can vary significantly from state to state, and even metro to metro as each area emerges from the downturn at different paces. 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 all the way down to the county level. 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.

At the end of the third quarter, the U.S. Phase I market was up by two percent nationally (YTD), yet regional growth was a high as eight percent growth in the North Atlantic, six percent in the Western region and five percent in New England. Michigan’s Phase I ESA market is seeing the positive momentum created by the Midwest commercial real estate market.

Mike Kulka, founder and CEO, PM Environmental, Inc. had this to share: “Here in Michigan, I am seeing demand for property due diligence at an all-time high. There is a tremendous amount of interest, in particular, from out-of-state investors and lenders.”

Kashat agreed, noting that “the ESA market in Michigan has been robust and steady all year long and similar to what we saw in the last 6 months of 2014.” While property prices are up in markets across the country, new players are moving aggressively into the Midwest for more reasonable prices and healthy returns on investment.

Consider a few ScoreKeeper statistics that demonstrate what makes Michigan’s Phase I ESA market unique:

  • In the first three quarters of 2015, there were nearly 7,000 Phase Is conducted in Michigan, putting it on track to match, if not best, 2014 activity.
  • Michigan’s Phase I ESA activity grew by 3 percent in 3Q15 vs. 3Q14 (see graph).
  • Michigan is the 10th largest Phase I ESA market in the U.S.
  • In 3Q15, the Detroit metro ranked 13th in terms of market size among the top 50 metros in the U.S., accounting for a significant 44% of the state’s Phase I ESA activity.

One national trend that has helped Michigan, and Detroit in particular, is that there has been a strong renaissance in many downtown markets in the U.S. Investors are also targeting office properties in Midwest markets like Chicago, Columbus and Detroit in their quest for greater returns on investment and less intense competition for properties than in the gateway metros. Detroit, in particular, is emerging as a national leader in the reuse of long-vacant properties as developers swoop in to take advantage of low property prices, and an expanding suite of public and private initiatives. One of the primary factors fueling the Midwest’s continuing renaissance is the region’s status as a popular destination for startups and high-tech firms. Detroit’s office market used to be one of the worst-performing in the U.S. The city’s Class A office vacancy was as high as 30 percent during the recession and has fallen to about half that today. Due to the improvement, PricewaterhouseCoopers just ranked the city tenth in the nation for industrial property investment, and the metro is expected to “significantly outperform” the regional average in 2016.

Nationally, foreign investment in U.S. commercial real estate is at an all-time high, and it is having a significant impact in Detroit as global investors continue to be active—particularly in areas outside of the city’s urban core.

“Geographically, Detroit and its suburbs are obviously hot,” observed Kulka. “What is good to see is that activity is also starting to expand beyond Midtown, Corktown and Downtown. Grand Rapids and Lansing are very vibrant as well.”

Detroit’s healthy activity drove Wayne County’s Phase I ESA activity to 10 percent growth in the third quarter, second to Macomb’s 19 percent. Noted Kashat, “Although due diligence activity seemed to slow during July, a high level of activity remained consistent in our urban core areas, mainly Detroit, Lansing, Saginaw and Grand Rapids with new acquisitions and redevelopment outweighing refinancing in those areas.”

Near-Term Forecast

For commercial real estate, this has been a long drawn-out recovery from the Great Recession. As the end of 2015 approaches, anyone whose business relies on a healthy flow of commercial real estate transactions can be reasonably optimistic about the near-term and take solace in the fact that conditions are steady and holding their own. It is important to understand, however, that the pace of growth is moderating from the early days of the recovery. Flat to slow growth truly is the “new normal.” Other trends to look for over the near term include:

  • Increasing popularity of smaller metros.
  • Modest increases in originations, and refi activity to peak in 2016.
  • More due diligence activity at Class B properties with the potential for environmental and structural issues.

Environmental due diligence in a recovering market is critical. Investors are looking closely at any issues, including environmental risk, that could impact the underlying value of a property. At this later stage in the real estate cycle, investors are even more selective because they can no longer assume that the market will be in their favor when they are ready to sell the property down the road. Likewise, banks are also behaving and managing risk more carefully than they were in the last cycle. As 2015 comes to a close, the forecast is for a busy 2016 in commercial real estate, followed by a slower 2017. For environmental due diligence firms, key strategic efforts should focus on the most active players in property investment and lending, as well as in the metros and states attracting the most interest in today’s market.

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