WHAT MEGA TRENDS ARE RESHAPING COMMERCIAL REAL ESTATE?

NOTE TO READERS: Below is an article that was just published in the Summer edition of the EBA Journal. The focus is on how broad trends like office-using job growth, site reuse and risk tolerance are impacting our market. The article also includes a sneak-peak at the top 10 metros in the Phase I ESA market this year and the insights of industry insider’s on how approaches to risk are changing as lenders prepare for the next downturn. Thanks to EBA President Bill Sloan for permission to reprint this article here, and to the EBA Journal editor Elizabeth Krol, Partner Engineering and Science for featuring it in the summer edition distributed at the Philadelphia summer conference last week.

With 2019 now almost at its midpoint, the economic expansion marches on. The positive barometers in the market leave little room to worry about a drastic recession over the near-term, yet commercial lenders are wise to keep their feelers out for signs of a shifting market. A notable characteristic of the market this year, in addition to rising market caution, is the rise of what our PRISM keynote speaker, Spencer Levy, calls “The New City.” Risk managers at financial institutions have their gaze fixed on the horizon for changing winds that could shift the risk equation. While the forecast for commercial real estate is still positive over the near-term, there are strategies that leading institutions are already implementing to mitigate any potential adverse impacts of a slowdown in the market in 2020 or beyond.

1) Behold the Emergence of “The New City”

Levy, CBRE’s chairman and chief economic advisor, addressed a number of the megatrends that are shaping commercial real estate. Front and center was his take on those smaller secondary and tertiary metros that are “new and hip and attracting top talent.” These are the urban areas experiencing the emergence of talent clusters, particularly tech talent, where the market is seeing bigger companies gravitate. “The new city money,” Levy observed, “is flowing into secondary markets that have that trifecta of: talent creators, talent attractors and live-work-play developments.” From a property and commercial lending perspective, the truly exciting element of this trend is that companies will look for properties in the right locations, some of which will be ripe for reuse and redevelopment. Today’s Class C industrial, for instance, could become tomorrow’s Class A office space. That is where the opportunity lies.

2) Office-Using Job Growth is Key

“If you can project where the office-using jobs are going to be, you can project everything!” ~Spencer Levy, CBRE

I am often asked by environmental due diligence consultants and risk managers at financial institutions which regions, states or metros are growing so I was interested to see where CBRE is forecasting the strongest activity. The key, according to Levy, is where the jobs of tomorrow will be. Jobs impact virtually every major asset class: where apartments are built, where retail demand will be strong, where companies need office space and so on. CBRE’s top 20 markets for forecasted office-using employment (see the figure), are led by the usual suspects like San Francisco, Austin and Dallas. Below the top echelon, however, you also see the growing strength of smaller metros like Tampa, Salt Lake City, Nashville and others.How does that forecast of hot job markets mesh with this year’s top markets for Phase I ESA activity? A sneak peek at the metros rising to the top so far in 2019 in advance of midyear stats is as follows:

In a Phase I ESA market that was relatively flat in the first four months of 2019 compared to last year, average growth across the strongest markets was in the double digits according to EDR’s ScoreKeeper model. The 10 metros in the table grew by an average of 13 percent, led by strength in Memphis, Richmond and Cleveland—all secondary commercial real estate markets. Miami, a metro ranked 13th on CBRE’s list of forecasted office-using job growth, is already having a strong year as the sixth fastest-growing Phase I ESA growth market this year. If Levy is right, then we will start to see some of the other high-growth office-using metros like San Francisco, Austin and Dallas, appear on this list in the second half and beyond.

3) Lenders Shift Their Gaze to Recession Preparedness

Signs that the record-long economic recovery is nearing its end are shifting the focus toward recession-proof risk management strategies. Thanks to an attractive commercial real estate deal-making environment, property lending is still robust, but the market is as competitive as ever, particularly as non-bank lenders aggressively compete for a piece of the pie. At this late stage of the cycle, lenders need to keep a watchful eye on changing market dynamics.

Value-add is more attractive end-of-cycle with limited “buy” opportunities, and investors and lenders are warned to take a more reserved, judicious approach. Are lenders stepping back from robust risk management? No, according to EDR’s most recent industry survey, the 2018 Benchmark Survey of Environmental Consultants. The results from the more than 500 consultants surveyed showed that:

  • On average, 22.4 percent of Phase I ESAs lead to Phase II investigations, up from 16 percent a few years ago.
  • Nearly 20 percent of respondents indicated their lender and investor clients were more risk averse in their environmental due diligence, higher than the percentage that were less risk averse–with the majority holding fast to their current practice.Dev Strischek, Principal, Devon Risk Advisory Group at last fall’s RMA conference, observed: “You lenders are all out there throwing money around like a food fight in a National Lampoon movie. There’s a theme emerging right now that it’s probably time to batten down the hatches.” Strischek moderated a PRISM track titled Recession Preparedness: Asking the Right Questions in which he asked a panel of risk managers to share how our market is different today than pre-recession. All pointed to stronger operational processes for risk management with a tip of the hat to technological advances that make risk data easier to process. Also worth mentioning is what Michael Bell, Founder and President, Bell Oldow, Inc. observed:

“Deals are becoming more complex the deeper we get into this expansion. From the perspective of a third-party Phase I ESA reviewer, as deals get more challenging there are often more complex environmental issues that consultants should highlight, analyze, and discuss. These are the known and potential risks that Phase I users such as bankers and other dealmakers, should be considering in their current and future cash flow models to protect their companies from economic losses. Unfortunately, what I have seen recently, as competition for successfully closing deals increases, is that big and small Phase I providers are incorrectly labeling Recognized Environmental Conditions (RECs) as Environmental Business Risks or De Minimis conditions, softening the impact of the Phase I and “allowing” lenders to avoid policy requirements to address RECs in the deal write-up. Although this process allows deals to flow more smoothly in the short term the impact to the company if they need to take ownership of that same property during foreclosure could be a big problem.” ~Michael Bell, Bell Oldow, Inc.

Another key change in today’s market is the emphasis on mitigating vapor risk. “I’ve seen more frequent further investigation due to vapor intrusion and the use of measures like vapor barriers as protective measures in cases where there’s a potential risk to tenants,” Bell noted. This is consistent with EDR’s benchmark survey results which found that 41 percent of consultants surveyed “always” consider vapor encroachment/intrusion risks during a Phase I ESA, a trend attributable to the growing attention this risk has received from the U.S. EPA, state/local regulators and ASTM’s Phase I ESA task group in recent years.

While no one is predicting an imminent recession, savvy risk managers are adopting strategies in advance of the next downturn. For instance, Marty Hall, CRI, Director, CRE Risk Management, BOK Financial, is making sure the bank’s younger staff is ready. “We have staff members who haven’t been through a recession so we’re now having our younger staff spending time with our workout group as a strategy to get them thinking about the risks that they may not think about on their own. We’ve also been very diligent in making sure we maintain the same overall concentration limits for commercial real estate exposure throughout this recovery period.”

Rigorous due diligence and stress testing are also imperative at this stage of the cycle. Bell noted that:

“It’s wise even while the market is still growing to do some stress testing. Look back at your portfolio, either following an established watch list or generating your own high-concern list. Do some sampling in your portfolio especially if you’re using a common vendor. Look for trends in how consultants are classifying RECs and business risks. Since the prices of Phase Is haven’t changed in 20 years, there is a lot of pressure on consultant to satisfy their clients to maintain their deal flow and revenue. So the process today is much more challenging from the viewpoint of the assessor. Additionally, lenders should communicate with their Phase I providers to make sure that REC determinations are reasonable and in line with prudent risk management.”

4) Expect a Busier Second Half of 2019

Virtually every market analyst points to strong market fundamentals when asked that popular question: When will we see the next recession hit?

Despite the market’s positive performance in 2018, and still-healthy barometers thus far in 2019, forecasters at the Urban Land Institute are forecasting declines from the historic highs of 2015 and 2018 to a more sustainable path of transaction activity the next two years. The projected slowdown is largely due to the anticipated impact of rising interest rates and the fading stimulus from the federal tax reform package. That will likely result in more caution on the part of investors and lenders.

“While investors expect to remain active in real estate markets this year, they plan to be more conservative in their acquisitions. Increased caution, however, is counterbalanced by the search for yield in a late-cycle environment, which is drawing more investors into secondary markets.” ~CBRE, Americas Investor Intentions Survey 2019

Regardless of your prediction about Phase I ESA volume, robust due diligence is critical at this stage of the market. The danger is that the still-strong factors boosting today’s market (good fundamentals, access to capital, interested investors) can mask the risks, and encourage lenders and developers to overreach at this late stage of the cycle. It is comforting to see that our latest survey results indicate the market is not relaxing underwriting standards in a quest for growth in a challenging environment.

Leading economists across the board, including Levy, are predicting that “2019 is going to be a decent year.” Let’s hope they’re right! And don’t lose sleep trying to forecast the timing of the next recession. Bear in mind these wise words:

“Don’t worry about timing the next downturn. Buy the right asset and maintain quality underwriting standards, and you won’t need to worry.” ~Hessam Madji, president and CEO of Marcus & Millichap