Top 7 Reasons Alternative Lenders Should Consider Climate Risk

Since banks have retrenched from commercial real estate lending and interest rates remain high, alternative lenders have an attractive opportunity to fill the funding gap. However, lenders should proceed with caution given recent market volatility.

One way that alternative lenders can tactfully navigate potential growth opportunities is by screening investments for physical climate risk. Physical risk refers to the potential damage to properties caused by natural disasters such as flooding, wildfires, and hurricanes, all of which are becoming more frequent and severe due to climate change.

Moreover, climate risk is a variable that enhances a lender’s core strategy without being difficult to incorporate into existing loan life-cycle processes.

For alternative lenders looking to capitalize on the current real estate credit shortage, leveraging climate analytics to better understand a borrower’s exposure to physical risk may be the difference between accretive and non-accretive growth.

1: Mounting Liquidity Concerns Extreme weather causes billions of dollars in damage to the real estate industry every year. The National Ocean and Atmospheric Administration (NOAA) reports that the number of billion-dollar events in the United States increased from 3.3x in the 1980s to 20.0x over the last 3 years. Since insurance only covers a small fraction of total incurred losses, real estate owners are on the hook for costly property repairs.

Due to property damage and business disruptions, borrowers are often unable to make timely and whole mortgage payments. A 2022 study performed by researchers at University of Guelph, University of Southern California, and Maastricht University, shows that hurricanes Harvey and Sandy led to significantly higher delinquency rates for commercial mortgages in Houston and New York, respectively. The study further indicates that once borrowers miss a payment, the loans remain delinquent for approximately four to eight quarters.

Moreover, even if a property is located outside of high-risk zones, it’s not immune from the impacts of extreme weather since insurance premiums are rising nationwide. According to USI, a leading insurance brokerage and consulting firm, insurance premiums for U.S. properties outside of catastrophe-prone zones are expected to continue to increase by 5% to 10% in 2023. While certain property owners can share the cost increase with tenants, owners of multi-family properties, a preferable asset class in the current state of the market, cannot pass along these insurance expenses to tenants, further diminishing borrower liquidity.

Lastly, some insurers are cancelling policies in high-risk areas. For example, in May 2023 State Farm and Allstate, two of the largest insurance agencies in the United States, announced that they will no longer accept new insurance applications for business and personal property in California. For property owners in California that are unable to obtain insurance, the implication for liquidity in the event of a climate hazard is alarming. In aggregate, both the direct and indirect impacts from climate change will continue to create significant liquidity concerns for borrowers.

2: Value Disruption for Bridge Lenders There is growing evidence that climate risk in coastal markets – those most susceptible to storm surges and flooding – has already affected real estate prices. A 2018 study performed by Pennsylvania State University and the University of Colorado demonstrated an average 7% “sea-level-rise discount” for non-owner occupied coastal residential properties. Similarly, First Street Foundation released data showing that eight states lost a combined total of $14.1 billion in coastal home value since 2005 due to sea-level-rise flooding.

While loss of value is concerning for the entire real estate market, it’s most problematic for bridge and transitional lenders that provide capital at higher loan-to-value ratios for shorter durations. For these lenders, extreme weather has the power to not only wipe out borrower liquidity but also impair the market value of the underlying asset. In other words, an acute weather event may push a bridge loan into delinquency with little or no time for the underlying asset and its surrounding market to rebound before maturity.

3: Geographic Risk At the portfolio or fund level, geographic concentration is often measured at scale using the National Council of Real Estate Investment Fiduciaries’ (NCREIF) regional and sub-regional classification. Lenders and debt investors measure geographic allocation to ensure that the portfolio is weighted towards more productive regions without over-exposure to any single region.

However, a useful extension of geographic concentration is climate risk concentration. Since tangential regions may share many of the same climate perils. For example, NCREIF’s South region, except for southern parts of Texas, is high-risk for hurricanes, whereas NCREIF’s Western Pacific subdivision is high-risk for wildfires.

NCREIF Regional Divisions

Climate Impact

4: Counterparty Risk In addition to evaluating internal geographic risk, assessing the borrower’s geographic risk is just as important since loan performance hinges on the borrower’s ability to service debt. In other words, loans that are secured by low-risk properties are not truly low-risk unless the borrower also has a low risk profile. Factors that the lender should consider include the borrower’s other debt outstanding, geographic and climate risk exposure, and whether any mitigation measures have or will be employed to offset the risks. In the event of extreme weather, one high-risk investment can send liquidity shocks across an entire portfolio. Therefore, evaluating the borrower’s portfolio geographic risk provides lenders with a more holistic view on how much climate risk they’re taking on.

5: Mark to Market Risk Revaluation risk is highest during periods of market dislocation due to a change in demand and supply fundamentals. Although the value of assets managed by mortgage real estate investment trusts (REITs) will adjust quickly to changes in perceived value due to secondary market trading, the same does not apply to private debt vehicles. In the case of debt funds, the market value is typically derived from appraisals conducted at loan origination and revisited periodically for impairment testing. As such, there is often a value divergence between public and private real estate during periods of market uncertainty.

According to NAREIT, the public real estate index was down -24.9% for 2022, while the annual returns of private real estate were up 6.6% over the same period. The mark-to-market is important to take note of,because it can trigger an anticipatory sell-off, challenging overall fund liquidity. For example, following the public REIT mark to market in 2022, Blackstone’s private REIT (Breit) experienced a surge in redemption requests during the first quarter of 2023, approximately $13.7 billion. Although the current revaluation is attributable to the empty office buildings, it’s not hard to conceive that a similar disruption could be triggered by extreme weather. Currently, commercial real estate appraisals do not consider climate risk. However, the industry is exploring how climate change risks can be uniformly incorporated into appraisals to more accurately price and compare risks across the sector.

6: Refinance Opportunities for Maturing Loans With $1.5 trillion of commercial real estate loans coming due before the end of 2025, lenders will likely work through a flurry of refinance requests. Since most of these loans were financed at near zero interest rates, it’s likely that many will not be able to refinance the full existing mortgage amount. Instead, real estate investors will likely need to insert additional equity into existing deals to have them refinanced.

As such, there is natural de-risking that is already underway in the credit market. Only the best deals are refinanced with greater equity support and therefore downside protection. Alternative lenders should leverage the current flight to safety as an opportunity to use climate risk as a signal of quality. Climate analytics provide a data-driven view on short-term and long-term performance of assets under multiple climate scenarios.

7: Fundraising & Climate Related Disclosures Environmental, social and corporate governance (ESG) investing has gained significant traction and is on the way to becoming mainstream. According to the Global Sustainable Investment Association, ESG assets surpassed $35 trillion in 2020, up from $30.6 trillion in 2018, representing one-third of global assets under management. At this pace, ESG assets could exceed $50 trillion by 2025. Data from Morningstar shows that global sustainable fund flows hit a record high in 2020, with net inflows of $152.3 billion, underscoring high demand for sustainable investments.

Additionally, investing in climate resilient geographies may be less susceptible to greenwashing because it’s transparent and quantifiable. Therefore, raising capital for a debt fund with an investment mandate for climate resilient locations, is a unique opportunity for real estate lenders to take advantage of positive capital flows while boosting returns through enhanced risk management.

Lastly, shareholders are demanding that mortgage lenders disclose how their origination strategy aligns with investor climate priorities. Many institutional investors already require that the funds they invest in report physical risks in alignment with sustainability frameworks and/or benchmarks, including The Task Force on Climate-Related Financial Disclosure (TCFD), Task Force on Nature-Related Financial Disclosure (TNFD), and Global Real Estate Sustainability Benchmark (GRESB).

Overall, climate risk is an important factor to consider for alternative lenders when evaluating growth opportunities in a volatile real estate market. Since climate risk cannot be diversified away, real estate lenders need to proactively forecast and quantify the financial impact from climate change to better manage liquidity, protect the last dollar, and drive loan performance.

For more information on how Climate Alpha can help you get ahead of the impacts from climate volatility, reach out to our team