How Investors Stay Profitable & Mitigate Risk in a Late-Cycle Economy

Creative & Cautious: How Savvy Investors Stay Profitable & Mitigate Risk in a Late -Cycle Economy

Sponsored by Partner Engineering and Science, Inc.

By Joseph P. Derhake

Commercial real estate and financing outlook remains optimistic for the remainder of 2018, with steady but cautious growth in 2019. Construction lending continues to thrive, but materials and labor shortages, rise in cost and global tariffs threaten to increase project risk. CRE development has shifted towards secondary and tertiary markets, with high demand for multifamily development in suburbs. Office and industrial sectors are outperforming, and we expect that to continue into 2019.

Among our institutional equity clients, acquisitions are still strong, but limited supply means that our clients are getting creative. We’re seeing more specialized scopes in our physical assessments and more requests for “pre-feasibility” perspectives, as investors attempt to redesign, repurpose, even re-classify available properties. We’ve seen everything from big box retail converting to self-storage facilities to fast food stores becoming car charging stations. We expect this trend to continue as competition increases and consumer demands evolve.

Value add projects or rehab projects are favored to ground-up as the developer usually avoids entitlement risk. With repositioning or adaptive reuse comes construction, with all its inherent risk, and a correlating increase in bridge, mezzanine or “gap” financing. Careful risk management is key in construction lending, both in quantifying the risk through appropriate due diligence and mitigating default risk over the course of the project. Our construction risk management practice continues to grow as more buyers seek to rehab or reposition older assets and more lenders finance those efforts.

On the asset management side, portfolio managers are investing in portfolio-wide efficiency programs, identifying opportunities for energy and sustainability upgrades that reduce operational expenses and increase resale value. One REIT client reduced their utility bill by a million dollars per year through strategic energy auditing, then recommissioning just a portion of their portfolio: an effective way to cut expenses in the face of late-cycle economy.

Lenders, investors and owners should consider building resiliency when assessing risk, especially in coastal regions with greater vulnerability to natural disasters such as storms and earthquakes. Seismic retrofits, which are now mandated in several cities at risk for earthquakes, provide relatively economical options for minimizing loss, especially since seismic insurance is still expensive for property owners. Similarly, storm vulnerability can be mitigated through proactive due diligence, implementing building systems checklists and fortifying building envelopes and exterior features

Finally, the development and integration of transformative technology will drive commercial real estate to evolve or become obsolete. Increased reliance on ride sharing and a decrease in car ownership is impacting parking layout and responsive design for the urban market. The growth of e-commerce has had an even greater impact on industrial properties and goods delivery. As smaller businesses strive to keep up with Amazon and Walmart, demand for distribution facilities will provide opportunities for adaptive reuse, warehousing and hauling hubs and rethinking design.

Joseph P. Derhake is the CEO of Partner Engineering and Science, a national environmental and engineering due diligence consulting firm serving many of the nation’s largest lenders, real estate investors and corporations.

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