The Evolution of Managing Risk in Commercial Real Estate

By John P. Heffernan III, PE

The roots of risk management as it relates to the physical characteristics of commercial and multifamily real estate date back to the early 1970s. During that time, the appraisal, commercial property insurance, construction, and engineering industries actively began to seek ways in which to improve their respective areas of service. The goal was to depict more accurately the physical risk aspects of investing in, owning, and maintaining commercial real estate assets.

Risk Management by Way of Crisis

Hurricane Andrew’s almost-unprecedented devastation and cost in 1992 and the Northridge (California) earthquake in 1994 were wake-up calls for many insurers and highlighted the need for better risk analysis. Around the same time, commercial real estate experienced a jolt of an economic nature.

One way to view the evolution of commercial real estate risk management is by examining the events of the 1980s and repercussions in the early 1990s. In the 1980s, commercial construction boomed (see chart), resulting in a massive oversupply of commercial space and creating serious financial problems for many depository institutions and real estate investors. Many analysts believe those problems helped cause a broader credit crunch in the early 1990s, which reduced the availability of funds to small and midsized businesses and slowed overall economic growth.

Real estate lending by commercial banks grew strongly during the mid-1990s because it was expected to be profitable. Of particular importance was that such lending generated large up-front fees. In addition, many banks expanded their real estate lending because they were experiencing greater competition in some traditional business lines. For example, large corporate borrowers were increasingly turning from bank loans to commercial paper for financing. And liberalization of the rules governing lending and deposit-taking by savings and loan institutions also increased the competition facing commercial banks.

Savings institutions, such as savings and loans and mutual savings banks, also played an important role in the real estate boom and bust of the 1980s and early 1990s. Savings institutions were weakened when deposit deregulation caused a large increase in their cost of funds at a time when revenues were derived primarily from holdings of low-yielding fixed-rate mortgages. To stem the mounting losses, savings institutions were allowed to expand into other activities, such as commercial real estate lending. Some savings and loans used brokered deposits and other funds to rapidly increase their holdings of residential and commercial mortgages.

During the mid-1980s, the commercial mortgage-backed securities (CMBS) market came into existence. However, the real estate recession of the late 1980s and early 1990s, the failure of regional banks during that recession, and the resulting desperation for real estate capital produced a quantum shift in commercial real estate finance from regional banks to Wall Street and the world of CMBS. Above all, CMBS solved the geographic portfolio diversification issue. By pooling mortgages from properties all over the country, securitizing them into CMBS, then selling the CMBS on world capital markets, the risk of a particular property could be diversified far outside a given metropolitan area. Now, CMBS investors in Frankfurt, Hong Kong, and Buenos Aires could, in effect, each own a small piece of an office park in metropolitan Washington, its mortgage being part of the CMBS pool.

Until recently, there were virtually no standards for inspector qualifications, and the service became largely a commodity. Deferred capital figures were reported largely in manners not accurate to the property itself but rather as a vehicle to meet a specific reserve amount to facilitate a loan closing. Needless to say, this practice did not assist in the accuracy of forecasting in the commercial real estate investment banking market.

The Age of Property Condition Assessments

The property condition assessment (PCA) process began to formalize in the early 1990s as a response to the Resolution Trust Corporation (RTC).1 The process of performing PCAs became routine with the increased demand; however, there were still many inconsistencies. A 1995 Standard & Poor’s guide further defined the process, and in 1999, the American Society for Testing and Materials (ASTM) released a standard called 2018-99. Since 2000, tremendous growth in commercial mortgage-backed securities caused a spike in the completion of these reports because they were now required to complete a deal. Further, this growth has led to advancements in and convergence of the scope, methodology, and, in some cases, cost of PCA reports. However, the largest PCA assignments continue to be executed within the subcontractor business model also known as the CMBS subcontract model of providing PCA services. This model, coupled with the lack of professional certifications and liability protections required, has in many ways resulted in a perfunctory exercise in many transactions.

It’s important to discern, however, the difference between a PCA for the debt/CMBS markets and PCA for equity markets because the cost, methodology, detail, and value proposition vary tremendously. It was also the mid-1990s the Environmental Bankers Association formed as the formal vehicle that investment banks draw upon to draft and practice environmental assessment practices also using ASTM standards.

The assessment covers ten major areas, including:

  • building site (topography, drainage, retaining walls, paving, curbing, lighting)
  • building envelope (windows and walls)
  • structural (foundation and framing)
  • interior elements (stairways, hallways, common areas)
  • roofing systems
  • mechanical (heating, ventilation, air conditioning)
  • plumbing
  • electrical
  • vertical transportation (elevators and escalators)
  • life safety, ADA, code-compliant air quality (fire codes, handicapped accessibility, water/mold)

The PCA process generally consists of two phases: a site assessment and data analysis. The site assessment is a thorough and representative picture of the structure and above-mentioned building systems. But is that assessment enough?

New Landscape of Data, Analytics, and Risk Management in Commercial Real Estate

The users of a PCA include every interested party in a commercial property sale — seller, potential buyer, lender, investor — all of whom have sizable interest in purchase price negotiations, capital or strategic planning, and loan approval. It’s a high-stakes financial projection process that necessitates a better way to identify and minimize risk. Unfortunately, the PCA subcontractor business model, which minimizes the subcontractor’s liability, coupled with the banking industry’s appetite for commercial mortgage-backed securities lending, may be leading to a meltdown in CMBS of the magnitude of 2007.

For that reason, the risk-mitigating data and analytics contained and consistently used by the commercial property insurance industry are now an imperative addition to the PCA process. The methodologies to enact this change — thereby increasing the accuracy and finally raising the standard of quality of PCAs — include continuing education, augmented PCA reporting through data inclusion and appendices, and cooperation with agency lenders such as Fannie Mae, Freddie Mac, and HUD. A final methodology is the provision of a platform available industrywide to make these improvements available to the PCA consulting world.

  1. The Resolution Trust Corporation (RTC) was a U.S. government-owned asset management company run by Lewis William Seidman and charged with liquidating assets, primarily real estate-related assets such as mortgage loans, that had been assets of savings and loan associations (S&Ls) declared insolvent by the Office of Thrift Supervision (OTS) as a consequence of the savings and loan crisis of the 1980s. It also took over the insurance functions of the former Federal Home Loan Bank Board (FHLBB).

John P. Heffernan III, PE is assistant vice president of Verisk Commercial Real Estate.

Verisk’s Role in Real Estate Risk Management

Insurance Services Office, Inc. (“ISO”) was formed in 1971 with the backing of most of the existing property/casualty insurance companies. The objective was to consolidate and streamline existing intellectual property supporting the industry’s products in the marketplace and deliver more current and precise information to aid in property/casualty underwriting. ISO grew through the years and expanded its information collection beyond the property/casualty insurance industry. Today, ISO is a subsidiary of Verisk Analytics, a family of companies dedicated to providing data, analytics, and information services to help customers in insurance, healthcare, and financial services measure, manage, and mitigate risk. Thus began the development and maintenance of a database of detailed building and occupancy characteristics for more than 3.5 million commercial and multifamily buildings across the United States, which continues to grow today.

Until recently, the PCA industry has had virtually no standards for inspector qualifications and deferred capital figures were reported largely in manners not accurate to the property itself. However, the Verisk – insurance solutions commercial property platform has increased standardization for the commercial property insurance industry by developing underwriting best practices and providing unique risk assessments to improve pricing, underwriting, and risk selection. It is at this point in the history and evolution of the commercial real estate investment banking industry that Verisk Commercial Real Estate was formed — to bring to the industry what it has provided to insurers for decades — a national team of full-time property evaluators, a database of commercial properties and businesses, proprietary analytics, and risk management expertise.