Look ahead 2024: Existential risks arise for commercial real estate lenders, borrowers 

A higher for longer interest rate environment, a shift toward onshoring and the impact of climate change will all affect the way lenders need to assess risk going forward.  

Commercial real estate lenders and borrowers are looking at managing risk in ways that are not always congruent with the reality of today’s market, particularly as new and potential existential risks are arising due to the impact of climate change, the effects of regulations, a decline in globalization and a higher-for-longer interest rate environment. 

Barry LePatner, founder of New York-based law firm LePatner & Associates, which advises commercial real estate lenders and owners on large-scale construction and development projects across the US, believes the realities of commercial real estate investing have changed since the covid-19 pandemic.  

While some of those changes have been coincidental, others have been causative, LePatner said.  

“We are entering a period in which principals of leading investors and corporations are filled with uncertainty about new projects and it is necessary to figure out the right approach to identify the risks associated with lending, investing and development,” LePatner said. “There are new liabilities which are arising, and lenders and borrowers are making real-time decisions based on an older-time decision-making process and that is no longer applicable to these times.” 

Here are five things lenders should be thinking about when originating new loans. 

1. Insurance costs 

The cost of insuring commercial real estate properties in natural disaster-prone areas rose 20 percent year-on-year in 2022, per an October report from BlackRock, and commercial real estate lenders are increasingly concerned these increases will affect borrowers’ ability to service loans. 

These rising costs are one of the most significant areas of concern for commercial real estate developers and all conversations around acquisition and development projects, said Bert Crouch, a managing director and head of North America at Dallas-based manager Invesco Real Estate, in a story posted last month on Real Estate Capital USA. 

“Insurance used to be a box check. Now it is materially more expensive,” Crouch said. “If your average multifamily insurance is up 30 percent year-on-year and if you need catastrophe coverage or you’re in a market that has a higher probability of flooding or hurricanes or significant events, you’re seeing insurance costs are up as much as 200 percent or more.

“The reason why the insurance costs are more significant than interest costs in some ways is that these costs are above the line, so it is a capitalized cost adversely affecting value.”

2. Supply chain issues 

Construction and development is always fraught for lenders, which are at risk when the cost of materials rises unexpectedly or the availability of raw materials like concrete is constrained, LePatner said. The former issue could change the overall cost of the project while the latter would increase the construction period, affecting the borrower’s ability to repay as well as extending interest on the already-expensive construction loan.  

LePatner cited a situation in which he was working with a lender which had financed the development of a large-scale industrial facility. The developers planned to use tilt-up concrete panels, a process through which panels are made off site and then set into place to form the exterior wall of a new facility. But as the process to fund the loan was proceeding, despite review of the plans and specifications by the developer, the design team and an outside construction consultant, LePatner worked with the lender team to discover that due to supply chain issues, there would be a 16-month wait between when the order was placed and when the panels could be delivered.   

“It is hard sometimes for lenders and borrowers to grasp the residual extent of the post-covid supply chain problem. Nothing is guaranteed anymore.”   

3. Rising water costs  

While there has been substantial discussion around energy usage, there has been little around the impact of higher water costs on the balance sheet of a commercial real estate development. Eric Hough, chief commercial officer of San Francisco-based Epic Cleantec, which aims to work with large- and small-scale commercial real estate owners to implement sustainable water reuse solutions for properties. 

“The requirement for buildings to think more holistically about water re-use has been evolving. We have gone from fixture-based conservation to next step change for reducing water use,” Hough said. “This is now coming through recycling water rather than reducing usage through incremental steps, like cutting the amount of water used to flush a toilet from 1.6 to 1.28 gallons per flush. We are now in a place where we can reduce water usage by 50 to 90 percent.” 

The issue has so far been more prominent in the Western US, although Epic Cleantec is seeing more situations in which there are moratoriums on new developments unless a developer is able to prove they have a 100-year sustainable water supply, Hough added.  

“If you look at water and sewer utility costs across the country, they are escalating as fast or even faster than other utilities. We are seeing year-on-year increases of 10 percent, which may not sound like a big number, but if you project that out, it only takes 7 years before those rates double.”

4. Niche sectors, niche problems 

More commercial real estate lenders are looking to lend in niche parts of the market, particularly data centers. But there are concerns around the supply of power, with LePatner citing situations where a lender might be originating a data center loan to a developer, but the borrower has not done the appropriate due diligence to determine if there will be sufficient power at the outset and over the long-term of the project.  

LePatner worked on a situation in which a lender had originated a loan for the development of a data center in a rural area along the East Coast. Although the developer team had secured an agreement from the local utility to build a new electrical substation to power the data center, the developer had failed to secure what is called a “time of the essence” commitment from the utility. It was unclear if that substation would be online by the time the project was completed and a major tech company was scheduled to commence operations under a negotiated lease term, he added. 

“We needed to know if the local utility would be able to build the substation and if it would be ready to be commissioned by the time the developer needed it,” LePatner said. “These issues had not been identified nor had a commissioning third party been retained to ensure the viability of the power coming into the data center on day one. Risk management around issues like these always affect the lenders and we need to practice real risk management around these niche sectors.” 

5. Interest rates 

One of the biggest near-term concerns to the health of the commercial real estate market is interest rates, particularly because of what New York-based data provider MSCI says is a $1.9 trillion maturity wall through the end of 2026. Many sponsors with near-term debt maturities and loans indexed to the previous interest rate environment need rates to be lower to be able to refinance their debt, said Robert Gilman, partner and leader of the real estate group at New York-based advisory Anchin. 

But these sponsors might not be able to get the relief they need, Gilman said. 

“It seems that inflation is still rising and to me, it still seems like they will not be lowering rates anytime soon. No one has come out and said, ‘This is it, we’re done.’ Once that happens, there might be a little bit of an uptick in the market, but we are not anywhere close to that, and I don’t think that will happen before mid-2024 or later for that decision.” 

Outlook 

Market participants speaking with Real Estate Capital USA regularly use the word “interesting” to describe the market today, a catch-all descriptor which brings together a wide variety of assessments around managing risk today and what comes next.   

For LePatner, some of these risks are known while others are still emerging.   

“Higher interest rates and major supply chain issues are risks that were known about during and immediately after the pandemic ended, as was the potential for more inflation. There are also risks arising from what is being called de-globalization.

“Where 40 years ago, in the name of an oversimplified sense of market efficiency, entire supply chains of materials and products essential to real estate projects were moved overseas, the shock of the financial downturn of 2008 and the global pandemic proved the vulnerability of these moves. Construction was forced to come to a standstill as sourcing for products and materials from overseas sources were no longer reliable.” 

There is a need for greater supply chain resiliency, particularly around larger projects. 

“No party to a project indemnifies an owner or a lender against the steady drumroll of cost overruns and project delays that remain a pervasive fact of life. It is long past the time for the real estate, development and lender communities to begin to build in the additional due diligence into the project processes to protect themselves from these large, unknown risks,” LePatner added.