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 Corporation1 (RTC). 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)
• 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 way to better 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 melt-down 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.
Footnote - 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 Managing Director 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.
Im not sure how many folks are on this particular forum (seems like more follow only the ESA stuff, but lets take a shot.
I am looking to see how many folks, as companies or ICs do Freddie Mac PCAs.
They are taking the position of cracking down and enforcing, through the seller/servicers, the requirments for those doing the inspections/reports.
they are as follows, straight from the guide:
A consultant performing inspections and preparing property condition reports must have ALL
of the following qualifications:
I am working with a client to discuss this and its ramifications (extensive) with Freddie so I am gathering data.
Of all of us out there doing this work, how many actually fully meet these specific criteria? How many are doing Freddie PCAs that dont meet this? Raise your hands please. If you are with a mid to large consulting firm, take a guess at the percentage or what your drop in capacity would be if you could only use these people for the PCA, perhaps also sending now a 2nd person for the ESA.
I want to develop a set of suggested alterations to the guide requirements that will satisfy their need/desire for the proper professional background, and experience without sacrificing those that are qualified in reality and do good work.
Any other input, such as how this will affect fees, timeframes, etc would be appreciated. Feel free to pass onto anyone with a vested interest
For those of you that perform and order HUD PCNAs, major changes are afoot. I've summarzied the proposed changes here for everyone.
HUD is in the process of revamping the Project Capital Needs Assessments (PCNA) procedures and it is going to significantly impact the way we perform our field inspections and the reports we generate. The following is a list of the major changes to HUD’s process:
1) The PCNA’s will now be based on an expanded scope to the ASTM PCA process
2) Accessibility – Accessibility is becoming more on the forefront and is going to continue to be scrutinized heavily. We will now have to make much more detailed accessibility reviews for properties built after 1991. There is so much more that they are going to be expecting out of these reviews it is going to double time on site to make all the measurements and analysis. The adaptability of structures, i.e. first floor apartments (buildings without an elevator) and all units on buildings with elevators need to be considered adaptable for someone with a handicap. They want to know if things like wood blocking is behind the drywall so that grab bars above the toilets can be added at a later date. If it can’t be determined with a stud finder HUD wants destructive testing to inspect in the wall to find out. No more making assumptions or saying the condition is hidden or nknown. Every public accommodation (leasing offices, pools, etc) must conform to ADA standards. The Fair Housing Act requirements fall into any building built after 1991. If the apartment has federal assistance (Section 8) then the UFAS accessibility provisions come into play as well. Any deficiencies found must have a supplemental report submitted that includes schedule for correction, costing information, and could potentially require construction specifications and architectural drawings.
3) Forensic Examination – This is the most significant of the proposed changes. Any building that is 30 years old or older is going to require a level of testing that the industry hasn’t seen before. The logic behind HUD’s thinking is that most major building systems have an expected useful life of 30-50 years. Once the building gets to this age they want to know a lot more specific information about the condition of the building systems in place.
This examination work could involve things like:
a) Having elevator contractors on-site to determine condition of elevator machine equipment
b) Scoping sewer pipes with cameras to determine condition of the piping
c) Infrared scanning for moisture issues
d) Drywall removal in areas to observe hidden conditions like electrical wiring, and plumbing piping
e) Boiler flue gas analysis
f) Building Envelope studies for moisture issues
g) Roofing core sampling
h) In-depth HVAC equipment analysis
i) Etc. as determined appropriate for the building and systems installed
4) Shelf life – The PCNAs will now have a six month self life. Anything older will require an update and more than likely another visit to the site.
5) 10 year updates – the owners will have perform updates to the PCNAs at 10 year intervals where there could be changes to the annual deposits. The owners must bear the cost of these updates
6) Reserve Term Tables – The tables will be changing from the current 37 years to 20 years.
Right now these are all proposed changes (with no expected implementation date yet) but don’t expect to see much change before the final draft. The winds at HUD have shifted to this higher level of analysis and that isn’t going to change anytime soon. The long and short of this is the cost of performing PCNAs is going to be increasing significantly due to the increase in scope of work by HUD. There is a likelihood that additional services will be warranted depending on what is found on site (i.e. if a corrective action plan needs to be submitted due to an accessibility issue). Buildings that were built in the 1983-1990 year range fall into an area that won’t require more scrutiny for the time being.
What role do you think property condition assessments (PCAs) play in the recovery of the market?
According to Bill Tryon, director of technical quality at GRS Group:
“PCAs are more important than ever. In the market downturn, many property owners deferred major maintenance and replacements, which can significantly impact the value and cash-flow of properties.”
Confidence is returning to the market causing more buyers and lenders to step up their game and focus some attention on neglected properties that have had little to no activity over the past few years. Potential investors are paying closer attention to environmental due diligence amid the high risk aversion that still exists in the market and buyers want to avoid getting caught up in a deal where a property has issues that may cause devaluation. As a result of these factors, PCAs are playing a more crucial role in due diligence as a way to identify any material, structural issues, as well as augment the property appraisal process.
PCAs are important for financial institutions, as well. Mike Kulka, P.E., founder and CEO of PM Environmental stated that "over the next few years, more financial institutions could adopt PCAs as a standard part of property assessments." According to Kulka, in a recent panel including environmental risk managers and appraisal professionals, "three large banks all stated they see great value in PCAs and see this as a growing area in the due diligence group at their institutions."
Now, here are a few questions for you:
1. Do you believe that PCAs hold value in the property assessment market?
2. What variables affect the cost and turnaround time of a PCA?
3. Have you seen more PCA work coming down the pipeline for your firm lately?
4. Will PCAs continue to be relevant further into recovery, and if so, are they more likely to be bundled with Phase I ESAs?
Sean Dundon of Blackstone Consulting, David Drummond of Key Bank, Mike Kulka of PM Environmental and Bill Tryon of GRS Group weighed on the questions above and shared more insights on the role that PCAs play in the recovery, the value of PCAs and whether bundling PCAs with Phase I ESAs creates a competitive advantage.
You can continue reading this EDR Insight article to see what they had to say.
ASTM Standard Guide for Property Condition Assessment, E-2018, must be reauthorized to avoid sunset of the standard. Also, the appendix should be updated to reflect changes to ADA requirements, and a few minor revisions such as discussion of the continued viability of reports and estimation of reserve costs have been suggested. This meeting is intended to identify stakeholders, key areas of interest, and task group volunteers. In order to avoid sunset of the existing guide, the intent is to limit changes; however, additional changes will be considered for future revisions.
PCA Task Group Meeting - Task Group Chairs: Bob Barone and Bill Tryon
Date: Wednesday, June 5, 2013
Time: 1:00 pm, Eastern Daylight Time (New York, GMT-04:00)
If you would like to join us but have not received an invitation from ASTM, please send me an email at firstname.lastname@example.org to be added to the distribution list.
It does not appear that there is much in the way of discussions or active membership in this forum. Are all of the discussion getting put in the ESA forum instead? I wonder if posting here is worthwhile.
Is anyone else sitting in on HUD's presentation regarding requirements for the evaluation of accessibility? What they seem to be asking relative to Fair Housing goes far beyond Tier I or even Tier II ADA assessment contemplated by the 2018 guideline.
I'd be interested in what others think on this.
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Our company is seeking a Subcontractor or Independent Representative with a Professional Engineer's License for occasional peer reviews of Property Condition Reports. We are not seeking to fill a fulltime position, only a P.E. for occasional peer reviews of Property Condition Reports on a per project / contract basis. If qualified and interested or if you have any questions whatsoever, please reply to this post or contact us via the link below.
Rutledge Realty Solutions, LLC
I am buying a half acre parcel. The owner had an in-ground hydraulic auto lift installed on the property that he removed while I was in contract. THis work was done without permits or inspections and I was never informed of the lift. I happened to drive by and see the the equipment being loaded onto a trailer with an excavator. I later leanred trough a mutual aquaintence that the lift was aquired from a defunct auto repair shop, installed and used on the on the property to work on his many vehicles. What environmental and legal issues might this present?