Investors In Commercial Assets Move Beyond Financial Risk And Now Scrutinize ESG Factors

Risk is beginning to be analyzed a little differently in commercial real estate.

Investors taking a stake in commercial mortgage-backed securities or commercial properties are no longer just interested in simple loan-to-value ratios and net operating incomes when attempting to spot underlying risks. They are now spending more time studying the potential impacts from environmental, social and governance criteria, otherwise known as the ESG investment factors, on buildings. 

This is being codified by rating agencies and data firms that are now looking at a building's net carbon emissions, healthy air components, long-term sustainability and the ethical framework governing stakeholders tied to each and every building transaction before issuing a final rating for investors on CMBS deals or other commercial transactions. 

"For sure, in our corporate clients who are buying and selling and managing commercial assets, those [ESG] elements of diversity, human rights, consumer protection, the structure of management and who's on your board ... those kind of things are a bigger deal than I would have ever thought," said Anthony Romano, CEO of CREtelligent, a data firm that provides comprehensive due diligence solutions for parties trying to understand the fundamentals behind a CRE transaction. 

The shift to rating ESG-type factors when it comes to commercial real estate collateral is tied to growing recognition that factors like social risk or supply chain disruptions and violent weather can cause great losses to properties. 

Just one weather event, such as Hurricane Harvey, can cause billions of dollars in property damage. Harvey sped through Houston in 2017, leaving $125B in total economic losses in its wake, according to the National Oceanic and Atmospheric Administration’s National Centers for Environmental Information and the National Hurricane Center.

Buildings built before 2000 had an average loss claim of $154,928 after Harvey swept through, according to the Federal Emergency Management Agency. 

The personality of management also is becoming a critical factor, as corporations' culture, diversity and treatment of employees are increasingly being scrutinized before contracts are awarded. 

Romano said his firm spends time before, during and after each transaction using tools like Radius and an internal asset management monitoring system to figure out what factors could put an insurance company, corporation or lender more at risk when it comes to the commercial collateral they are buying or holding.

In many cases, banks and corporations are requiring the inclusion of these ESG factors when conducting new deals. 

"When a firm is looking at a market ... and you are going to do site selection on 10 to 15 properties in the market, those other data elements ... find their way into that decision," Romano said. "I see more corporations involved in that, and more bank policies are starting to dictate [it]."

Credit ratings agencies are also starting to wrap ESG features into their analyses.

"We now have formal criteria that lays out the environmental, social and governance factors that we will specifically look at in our underwriting process," DBRS Morningstar Vice President of North American CMBS Kevin Augustyn said.

DBRS Morningstar is now using a formal checklist procedure where all transactions, pooled or single-asset, are graded based on ESG issues, he said.

It analyzes the environmental impact by studying three components: the population, effective carbon and greenhouse gas costs, and climate and weather risk. 

Augustyn said he hasn't seen the new ESG criteria throw CMBS ratings into dramatically different categories to date because much of the data has already been incorporated into standard rating processes, but he said there is room for significant change when it comes to the climate change and weather risk component. 

"There are increasing levels of data providers and data research firms that can provide us with information on catastrophic risk, storms, fires, things that arguably could be a result of changes in the climate," Augustyn said. 

This type of environmentally focused underwriting also evaluates the creation and operation of buildings that are LEED-certified or have some type of designation suggesting the building saves energy and is more likely to be sustainable over a longer period of time, according to DBRS Morningstar.

When it comes to corporate governance factors, firms like Morningstar, Kroll, S&P and Fitch also study the ethical and performance framework of all key players tied to a CMBS issuance or a commercial property deal.

"In governance, it's how are deals structured? How strong are counterparties? Do the various servicers have the capacity to do what they are supposed to do?" Augustyn said. 

And finally, social factors, which include everything from market conditions to the human rights of employees and players involved in CRE transactions, are evaluated when using the new ESG-focused CMBS criteria at DBRS Morningstar. 

"We are focusing on the social characteristics of our services and counterparties," Augustyn said. "We want to make sure the labor practices, the human rights practices for the servicers, counterparties and people involved in the transaction is appropriate and that they will be able to attract and manage and have a staff in place to take care of those credits that they have been assigned."