As we look ahead to a new year, and commercial real estate enters the late stages of the current cycle, transaction volume is cooling slightly, and there has been a greater focus on smaller deals being done (by $ size and volume), especially in the still-robust secondary markets. Overall industry sentiment remains optimistic, with experts not expecting as detrimental of an impact as during the last recession.
While no one can forecast with certainty, 2020 should see industrial investments continuing to stay hot, with adaptive reuse and repurposing opportunities for retail properties that suffered from “store-pocalypse,” multifamily will continue to remain steady amidst a strong economy and tenant demand, and a moderate growth in office opportunities, helped by strong job growth, low unemployment, and demands for energy efficiency improvements!
Risk management is a growing focus for lenders, with surveys indicating more rigorous underwriting requirements for 2020, and some recession planning by banks underway – having junior staff shadow workout groups and doing stress testing, for example. Likewise, investors are also preparing by offloading assets that won’t be desirable in a downturn, and turning their focus to smaller deals and opportunities for repurposing or repositioning existing assets.
With savvy commercial real estate stakeholders balancing caution and optimism, and good deals still left to be found amidst slowing sectors, below are the five top risk management trends that will define transactions in 2020.
1. Due Diligence for Transactions is Critical As the commercial real estate world recovered from the Great Recession over the last decade, and the industry boomed like never before – creating entirely new sectors along the way – some investors and developers threw caution to the wind when it comes to managing environmental or physical risk. With a slowdown in the CRE cycle, and a potential recession on the horizon, now is not the time to skimp on due diligence. It is more important than ever to engage a knowledgeable, experienced consultant to help you limit liability and property risk, whether for existing buildings, a development site, or ongoing construction. An increasing trend in group funding and tranches means satisfying multiple stakeholders, all of whom may have different risk tolerances and different business stakes. Optimizing a transaction means making sure everyone is cohesive, and due diligence is an essential part of that. You may not always need a Cadillac, but even the smallest deals need attention towards risk management.
2. Maximize Building Assessment Data for Asset Use One of the most useful due diligence reports you can order is the Property Condition Assessment (PCA) report, which can give you detailed insight into the current condition of building systems and managing future repairs and cost reserves. This is especially critical at this stage of the cycle, when value add projects like rehabilitations, remodeling, or repurposing may be better investments than ground-up development. When ordering a PCA from your consultant, consider getting raw data along with the report. A report itself is a static snapshot of the building’s condition and possible future needs (for example to get a yes/no on the loan), but the consultant is getting valuable data for you that is helpful to track over time as you manage your asset. And remember, a database like Excel is just one way to handle the data. There are many facilities management system databases and software such as 4Tell Solutions or Uniformat, designed for gathering real-time information for facilities and capital asset management. Secondly, consider the type of building assessment needed for use. How sophisticated is the stakeholder? Who will use the data and how? Different stakeholders use building assessment data differently. A portfolio investor needs an equity-level PCA, with detailed data about systems and options for segregated cost table reserves. But if a REIT is buying a building for their own investment portfolio, in addition to doing a PCA, they might consider a Facility Condition Assessment as well, satisfying both their underwriting and their long-term use needs.
3. Industrial & Warehousing Developments Buoyed by e-commerce retail and the expansion of deliveries and last mile logistics, industrial and warehousing will remain a hot sector and will continue steadily in 2020 with lots of room for growth and build out. While there are plenty of opportunities to explore industrial projects or add warehouses to asset portfolios, they also provide tons of valuable insight about transportation corridors and future infrastructure needs. An equally beneficial opportunity may be the secondary and tertiary growth around the industrial areas popping up. For example, a new hot industrial area may get built near an exit on a freeway. But think about what happens next. The workers need a place to live nearby, places to shop, and local anchors. Inevitably, small communities grow around industrial investments, particularly those with transportation hubs nearby. Consider all of those needs when taking advantage of this sector. You don’t have to be the first on the block, but you also don’t want to be the last one. For Brownfield redevelopments or rehabilitation of distressed assets, there are risk red flags all over the place. Construction risk management, environmental and seismic risks are essential. In addition, pay attention to geotechnical assessments, as you have to be careful about the types of soils, clays you’re building on, especially if you’re an out-of-state developer.
4. Regulations are Here to Stay Even 3-5 years ago, regulations didn’t have as much of an impact on transactions, either with regard to expenses or compliance requirements. That has changed and will continue to be an important consideration in 2020 and beyond. There is much more concern now about human health of occupants, residents, the people living/visiting/working in buildings and what they are exposed to. Vapor intrusion, gases and “unseen” contaminants in particular are the focus of tightened regulatory attention. As an example, states are regulating radon much more tightly, as well as who is qualified to collect and transfer samples during transfer, which can push up due diligence costs significantly. This can present a learning curve for stakeholders and slow down (or endanger) deals if not done correctly. When it comes to adhering to mandatory regulations for transactions, engage with consultants who can do it right and factor in costs into the overall deal.
5. Owner’s Rep for Managing Construction Risk When helping an owner understand and mitigate risk during construction process, typically it’s about protecting the money dedicated to the project. The goal is to make sure that the money allocated for the development never gets too far ahead of the process. Construction risk management tools such as funds control and disbursement, document and cost review, and progress monitoring are essential for helping manage project timelines and budgets. A big trend for next year is the addition of ongoing owner’s rep services, to look at the quality of construction and making sure things are getting done the way that they’re supposed to. An engineer and/or architect with experience can be on site on a daily basis physically making sure that the ongoing construction is happening according to the plan. This can be tailored to different levels and needs, such as detailed line-item construction budget, time (project deadlines), and the quality of materials and the labor being performed according to project specifications.
Every year, there’s an availability of more properties, and with it, more opportunity to take advantage of the value of commercial real estate. At this late stage of the cycle, most of the good assets are no longer moving – it’s the lesser assets or riskier properties where the true opportunities lie, especially for broker clients, smaller regional banks, and rising alternative lenders. While these assets are more affordable, they also come with greater risk. Whether 2020 sees you managing existing projects or taking on news ones, engage with consultants who can help you manage risk, keep abreast of changing technology and regulatory landscapes, and optimize the value of your commercial real estate assets.