Recovery, Optimism, Caution: A Look at Risk Management in 2016

NOTE TO READERS: This brief, authored by EDR Insight’s Dianne Crocker, was just published in the January 2016 Commercial Real Estate Direct’s Year-End 2015 edition.

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RECOVERY, OPTIMISM, CAUTION: A LOOK at Risk Management in 2016

The environmental site assessment market continues on its path to recovery, along with the broader commercial real estate market. The good news is that based on EDR Insight’s internal research and its broad-based Commercial Property Due Diligence Fall Benchmark Survey (November 2015), the forecast for 2016 is a positive, but with some notable changes emerging.

More Investors, More Capital

The commercial real estate market has benefited from a robust pace of deal making over the past several years. One of the most promising recent trends is the growing universe of investors and lenders. The number of active buyers in commercial real estate has increased three-fold since 2009, new non-traditional lending sources are entering the market and foreign investment is at an all-time high. Financial institutions, particularly regional banks, are finally playing offense again. However, heightened interest in the United States commercial real estate market is not without its challenges. Well-capitalized players are crowding the field, and investment managers are feeling pressure to put that capital to work in a highly competitive marketplace.

Secondary Metros Are Hip

One trend that is expected to define 2016 points to a strategy of essentially making the pie bigger by looking at smaller metropolitan areas for opportunities. 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.

Smaller secondary markets with strong growth profiles are seeing investor interest. The accompanying table shows the 10 metros with the highest growth in 2015 environmental due diligence activity. Worth noting is that this table looked quite different several years ago when the highest growth occurred in the big gateways. Now, smaller metros like Las Vegas, Baltimore and Portland are attracting new attention from investors and lenders as they crawl out of the recession. Capital is moving into secondary cities in ways that these areas have not yet seen since before the downturn. It moves activity beyond San Francisco, New York, Houston, Seattle, and several other markets that were the strongest over the past few years. Among the hot spots being forecast for 2016 are Charlotte, Dallas, Austin, Seattle and Atlanta. Common denominators among these are low costs of living, perceived “hip” cultures, strong transportation systems and growing millennial populations.

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Risk Aversion Still High

Risk management this year will be different than in prior years. The market is hyperactive and awash with capital, so finding good deals requires more prudent due diligence. Regulator 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.

As the era of record-low interest rates ends, buyers can no longer assume the market will go their way, so there will be a need to build in the downside of a deal. Higher interest rates have the potential to take away value very quickly. In contrast to a decade ago, when speculators would borrow the full cost of a property in the hope that the rising market would outpace costs, buyers are now more conservative. At this late 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. There’s also much more transparency than there was prior to the downturn, so that’s going to hold investors and lenders accountable in a way they haven’t been before.

EDR Insight’s Fall 2015 Benchmark Survey of Commercial Property Due Diligence revealed the latest trends on this front, including:

  • 53 percent of environmental consultants say their lender clients tightened environmental due diligence and are more demanding in terms of having thorough property investigations conducted.
  • Only 12 percent reported a loosening of underwriting standards.

Need for Speed

The pressure to place capital in commercial real estate is driving up pressure on providers, including environmental consultants, to complete due diligence in record time. In the past, it was not uncommon for an investor to have as long at four weeks to complete their due diligence.  Today, the average time for a Phase I environmental site assessment is 14 business days, but 40 percent of environmental consultants are “often” or “frequently” getting requests for an even speedier turnaround. Speed comes at a cost—68 percent charge investors and lenders a premium for faster delivery.

Forecast

Although the pace of growth is moderating from the early days of the recovery, market indicators point to continued increases in transactions. Other trends to look for over the near term include:

  • Increasing popularity of smaller metros.
  • Modest increases in originations and refinance activity.
  • More due diligence activity at class-B properties, with the potential for environmental and structural issues.

The moderate-growth forecast correlates very well with what survey respondents expect to see, based on our fall survey results. The bulls win over the bears. The majority of environmental consultants are expecting flat to moderate growth in due diligence activity next year (92 percent) and only a small percentage of the market (8 percent) is expecting a decline.

In terms of risk management, investors are being even more selective because they can no longer assume that the market will be in their favor when they are ultimately ready to sell their property. Likewise, banks are also behaving and managing risk in a more careful way than they did during the last cycle. Efficiency is paramount. Advances in mobile, online and cloud technology are rapidly accelerating the deal-making process, cutting paperwork and increasing transparency. The dealmakers and service providers who can be agile and responsive to the market’s need for speed will be the winners in 2016 and beyond.

ABOUT THE AUTHOR

Dianne Crocker is principal analyst at EDR Insight, the analytical arm of EDR, a national provider of data, risk management and technology tools and insight for property due diligence and compliance.

FOR MORE INFORMATION

For more intelligence on the commercial real estate market in 2016, access CRE Direct’s Year-End 2015 edition here, for articles like these:

  • Despite Some Bright Spots, 2015 Was Disappointing for CMBS by Trepp’s Manus Clancy
  • CRE Lending Faces Unprecedented Regulatory Pressure by Trepp’s Orest Mandzy
  • Property Sales Volume Climbs 18% in 20115; Pace of Increase Slowing by Josh Mrozinski
  • Wall of CMBS Loan Maturities Shrinks, Remains Daunting by Susan Persin
  • Federal Legislation to Accelerate Changes to Commercial Real Estate Sector by Martin Schuh and Christina Zausner, CRE Finance Council
  • Will the Music Stop? by Real Capital Analytics’ Jim Costello
  • Regulatory Compliance: Big Issue for Real Estate Owners by Seth Dotterer, SiteCompli
  • Crocker’s article, Recovery, Optimism, Caution: A Look at Risk Management in 2016, begins on p. 29.