Property Risks to Watch

At MBA’s recent CREF conference, the prevalent outlook seemed to be optimism tempered with uncertainty. Many in the commercial real estate lending space believe that things will improve over 2024 to varying degrees depending on the market and sector. The anticipation of future rate reductions and increased transaction volume is somewhat tempered by concern about risks that are still very present in the market, including distressed assets, insurance rates, and construction challenges. Below is a recap of the discussions around these risks along with mitigation strategies for lenders.

Property Condition as a Marker of Distress

Property condition was a key discussion point in several CREF panels – Michelle Evans, EVP and Head of Multifamily for Fannie Mae, commented that it is one of the first indicators that something is wrong. The condition of a property often serves as a potent warning sign of borrower distress. Deferred maintenance, neglect, and even poor housekeeping can point to underlying financial or operational challenges. When such conditions are apparent, there may be more serious problems under the surface: poorly maintained building systems, compromised building envelope, or structural issues, or other deficiencies that require costly repairs or upgrades and may impact the property’s value and marketability. By monitoring property condition as an early indicator of distress, lenders can address potential problems proactively. A good first step is ordering a Property Condition Assessment (PCA).

Even if a PCA was performed upon loan origination, changing building conditions warrant an updated assessment. If a collateral asset is showing signs of distress, an equity-level PCA may be the best way to mitigate risk. While equity-level PCAs cost more than standard ASTM PCAs, the additional depth and scrutiny provided by equity-level assessment is worth the investment, particularly if foreclosure is a possibility.

At MBA CREF, Kevin Palmer, Senior Vice President and Head of Multifamily for Freddie Mac, pointed out that property condition issues are a major focus for 2024. According to Palmer, Freddie Mac received a great deal of feedback in 2023 on how to address property condition issues. This has led to some adjustments of policies. “In general, it’s kind of heightened due diligence and surveillance,” Palmer said. “Key there is if issues are identified—if life safety issues are identified—that we’re notified immediately, that we’re working collectively to be able to address these issues very, very timely.”

Insurability Through Property Resilience

The landscape of the property insurance industry is shifting dramatically. Over recent years, frequent catastrophic natural disasters have led to skyrocketing insurance premiums and/or loss of coverage. As lenders continue to grapple with the impact of insurance rates and insurability, they are beginning to consider property resilience assessments and improvements as a way to get deals done. Resilience assessments consider regional, historic climate data and building-specific characteristics to evaluate the building’s exposure to climate-related risk and identify measures to increase its ability to withstand severe weather events. When scoped to align with an insurer’s underwriting criteria, resilience assessments provide data that insurers require to assess risk. Borrowers can use this data to lower premiums, or in some cases, secure insurance for difficult-to-insure properties.

Construction Challenges Warrant Increased Contingencies

Construction projects are facing unprecedented challenges as material prices surge, labor costs rise, and supply chain disruptions persist. In response, many project owners are increasing contingencies to buffer against unforeseen expenses and mitigate potential financial setbacks. However, increased contingencies may not suffice to protect construction lenders in the event of project distress or failure. To effectively manage risks, construction lenders must adopt proactive measures.

Good construction risk management (CRM) is comprehensive and programmatic, designed to minimize the risk of construction financing throughout the lifecycle of the project.

Pre-Construction: Inadequate plans, overly optimistic schedules and budgets, under-qualified contractors, and even an incomplete understanding of the end product can significantly impact the probability of success. Pre-construction risk management measures include Document & Cost Review (DCR), Contractor Evaluation (CE), and Project & Budget Review (PBR). Construction Phase: Construction Progress Monitoring (CPM) provides regular reporting to the lender regarding the progress of construction. Funds Control / Funds Disbursement (FC/FD) encompasses all of the activities necessary to manage the pay application and disbursement process to ensure quality accounting and valid, appropriate draw requests. Construction Completion Commitment: Owner’s Representative (OR) Services: typically engaged by project owners, Owner’s Representative services are an option for lenders on distressed projects as an alternative to foreclosure. An OR can determine the cause of project distress, restore communication between owner, contractor, and lender, troubleshoot issues and act on behalf of the owner (or lender) to see the project through to completion.

While the above are traditional, solid approaches to construction risk management, 2023 saw an increase in lenders using Project Completion Insurance, a policy that benefits the lender in the event of default. Easier and less costly than a bond, Project Completion Insurance allows lenders to finance projects for borrowers who require credit enhancement but do not qualify for bonds. Policies are issued in conjunction with traditional CRM services which reduce the likelihood of default.

Despite the shifts and adjustments in the CRE finance markets, the conversations and presentations from MBA CREF Conference were marked with a sense of anticipation for a positive trajectory for the year. While challenges persist, savvy lenders can use strategic risk management practices to continue transacting regardless of headwinds.