The soaring cost of capital and a wave of recent bank failures have put sustainability on the back burner for many mortgage lenders. However, when used appropriately, climate analytics can help mortgage lenders become better creditors.
Climate analytics help lenders better understand their climate risk profile as well as that of their borrowing base, which can be used to inform better credit decisions and enhance mortgage underwriting.
Regardless of whether you are required by regulation to measure climate risk, internally mandated to invest in sustainability, or need help meeting external ESG goals, incorporating climate analytics into the day-to-day lending activities will make you a more successful mortgage lender.
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 three 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 given 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 Erosion Over Time 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.
Since government-sponsored-entities (GSEs), like Fannie Mae and Freddie Mac, buy and securitize the majority of residential mortgages originated in the United States, residential devaluation exposes securitized mortgage holders to outsized risk. However, the GSEs are already working with risk modeling experts to determine how best to integrate climate risk and mitigation into their investment processes. Therefore, residential mortgage lenders seeking to sell mortgages to the GSEs will also have to utilize tools that help them better identify, assess, and price climate risk within mortgage pools.
On the other hand, commercial mortgage lenders typically lend capital for a much shorter time period but for much larger projects. Therefore, even a fractional loss in collateral value during year one will translate into millions over a typical three to five year loan horizon for commercial mortgage lenders. Additionally, having a view on total risk exposure, inclusive of climate risk, will be critical for financial institutions looking to defend their credit ratings during a wave of banking downgrades.
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 mortgage lenders 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 mortgage lenders with a more holistic view on how much climate risk they’re taking on.
5: Loan Extension Opportunities
With $1.5 trillion of commercial real estate loans coming due before the end of 2025, mortgage lenders will be flooded with a flurry of extension requests. Of the loans coming due in the current year and the next, hospitality and office loans face the greatest risk. In 2023 and 2024, 54% of hospitality loans and 40.9% of office loans are expected to mature, of which more than half are estimated to be on bank balance sheets.
According to the research director of U.S. Capital Markets at Colliers, banks may be willing to extend loans as long as they meet coverage ratios. In this case, loan extensions would help smooth out the maturity wall while allowing cash flowing loans additional time to work themselves out. Mortgage lenders that are considering loan extensions should do so while also evaluating the borrower’s climate risk exposure and how it will impact coverage ratios. Since climate risk has immediate and long term impacts on liquidity, lenders would benefit from incorporating climate risk into the credit analysis.
6: Mark to Market Risk
Revaluation risk is highest during periods of market dislocation due to a change in demand and supply fundamentals. While banks and other direct mortgage lenders usually have the most senior position within the capital stack, it’s always important to understand where your last dollars falls.
According to the National Association of REITs (NAREIT), the public real estate index was down -24.9% for 2022, primarily attributable to the empty office buildings as remote work continues to be the standard. Since climate risk is not currently incorporated into appraisals, it’s not hard to conceive that a similar valuation disruption could be triggered by the increasing frequency and severity of extreme weather. As such, the valuation industry is already exploring how climate risks can be uniformly incorporated into appraisals to help mortgage lenders more accurately price and compare risks across the real estate sector.
7: Climate-Related Risk Disclosure & Regulation Many mortgage lenders already have ESG teams, which are responsible for developing internal sustainability frameworks and identifying tools that assist with the firm-wide implementation. A comprehensive sustainability strategy should not only identify the likely climate perils that threaten future income streams, but also identify the appropriate tools to quantify, monitor, and manage climate impact over time. Incorporating physical risk into the investment processes is one way that mortgage lenders can meet both internal mandates and external commitments to sustainability.
Moreover, in January 2023 the U.S. Federal Reserve asked the top six U.S. banks to perform detailed climate scenario analysis (CSA). The pilot asks each bank to consider a range of climate pathways and measure its economic and financial impacts. Although the current exercise applies to six banks only, a similar requirement is expected to follow for a broader banking group. Therefore, U.S. financial institutions should get ahead of regulation by developing the capability to measure the financial impact of climate change across their residential and commercial real estate portfolios.
Lastly, stakeholders are demanding that lenders disclose how their origination strategy aligns with popular 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). Climate analytics can help mortgage lenders provide stakeholders this level of transparency.
Mortgage lenders should consider climate risk not only to prepare themselves for upcoming climate regulation, but to better understand the climate risk exposure of their borrowing base, so that they can make more strategic capital deployment decisions. Overall, climate risk is a variable that enhances a lender’s strategy without being difficult to incorporate into existing mortgage life-cycle processes.