That sinking feeling
How commercial real estate is at the intersection of a brewing ESG polycrisis
Last week, I spoke with a few people about an upcoming ESG and Financial Services presentation I’m giving in March. Inevitably, the conversation turned to what gets the attention of firms. Governance leads the focus, mostly in reviews of crises after the fact (think Enron, Worldcom, or the less extreme and more recent examples of SVB and Boeing). Unfortunately, or fortunately, even with growing climate risk and shifting social sentiment, the Environment and Social pillars haven’t risked a company’s entire existence yet.
Value erosion or destruction appears to come down to Governance in these high-profile cases. Will the Environment or the Social ever get the attention they deserve without a massive failure to wake companies up? As it turns out, a brewing polycrisis may draw closer scrutiny to these issues. A polycrisis is where multiple crises intersect to create a worse situation (WEF).
It’s a pretty good word to describe the complexity of the world’s effect on a company.
ESG represents a non-financial approach to long-term business value and an interesting framework for addressing interconnected risks. This is important to recognize as a polycrisis can intersect across all three pillars. For example, the SVB failure had Governance issues and challenges related to the Social (stakeholders). In fact, the singular stakeholder group causing a run on the bank augmented the issue of an absent Chief Risk Officer.
If the idea that ‘the confluence of ESG issues causes a worse problem’ gives you pause and a sinking feeling that something terrible is on the horizon, you are catching on!
For the first time, the markets might face an ESG confluence with global economic repercussions around commercial real estate. The funny thing is that the information we need to uncover this polycrisis appeared across five recent stories in The Financial Times over ten days. Unlike those individual articles, we will use ESG to connect the dots.
In Chapter 10 of my upcoming book, ESG Mindset, I write about commercial real estate as an example of ESG and interconnected risks. Here, I’ll take a slightly different look, using the examples from the five stories as the foundation to show how an ESG mindset can reveal risk.
February 13th - Insurance Costs and Climate Change
The uninsurable world: what climate change is costing homeowners
In the week’s Big Read, the FT team tackles the sharp rise in homeowner’s insurance premiums due to the rise of climate change catastrophes. Insurance losses from natural disasters only increase as events become supercharged, recently topping losses at $100B. As a result, industry executives are directly linking “manmade global warming and the insurance affordability problems.”
Homeowners insurance and its link to climate change have been in the news, especially in the US, with insurers pulling out of markets and Germany having reinsurance issues after periods of intense flooding. This issue directly impacts one of a company’s most critical stakeholders, its employees. Commercial real estate will suffer if employees can’t afford or obtain insurance in stressed regions, potentially creating new economic deserts where nothing but the buildings remain.
While the article focuses on homeowners, there is an excellent not-to-be-missed quote from Mia Mottley, prime minister of Barbados.
And it’s not just people. You’re seeing it with businesses and at some point it’s going to become an issue with respect to access to and quality of their loans.
Motley gets it.
In other words, climate risk isn’t only a homeowner issue but also affects all types of insurance, including commercial real estate. The liability for owning or leasing a physical location is increasing. If your company deals in tangible assets or materials in the value chain, climate change and extreme weather events are risks you cannot afford to discount. If your core business deals in intangibles, you might be better off without physical assets like buildings, but that change isn’t as easy as it sounds. Switching the workforce to remote doesn’t eliminate the risk. It just distributes risk across geographies but could introduce new problems.
Speaking of which…
February 18th - Social Sentiment around Remote Work
Work from home if you want but don’t expect a pay rise
Our second story quite literally hits home. The hybrid and remote work trend coming out of COVID remains strong. Workers in the UK believe working from home twice a week is worth a 6% pay raise, while 39% of US workers still prefer to work from home. Yet, some companies are mandating a return to the office even though “for every extra day an employee works outside the office, their productivity rises to the tune of about £15,000 a year.”
The article's point is that working from home isn’t for everybody, nor are companies getting it right, resulting in lower wage growth for remote workers. Paired with that productivity number above, we’re looking at a new extractive labor model.
But pivoting back to the commercial real estate perspective, the nature of work is changing around people and their preferences. In the UK, only 62% of workers show up in person, down from 98%. While I suspect a few may still be worried about COVID, many have found new patterns and routines that don’t involve much time wasted in a commute. I know I have!
Our gleaming office buildings are under-utilized and will remain so for the foreseeable future. Whether these buildings are loaned or leased, this Social trend represents a particularly challenging line item on the balance sheet.
February 19th - Cities are sinking
Sinking skyscrapers, new beaches: Chicago faces the climate crisis
OK, before we go further, a brief detour. On February 13th, The New York Times published an article/infographic titled The East Coast Is Sinking. About 30% of the US lives along the East Coast, with cities being places where people live, commute, and work.
But the FT story is a little different. Chicago is an inland city built on marshland along a lake. While it has been sinking since glacial pullback at the end of the last ice age, the contracting and expanding underground from related heat islands “can cause or exacerbate shifts, tilts, and cracks in buildings and infrastructure, and significantly raise repair and maintenance costs.”
Buildings are not at risk of toppling, but these costly repairs may keep some businesses hesitant to stay in an existing location, especially one that is older or at risk. Part of the challenge for any city is that fewer taxes come in as people work remotely, making public infrastructure repairs difficult but still necessary to fund. For a company, repairs and maintenance as line items on the balance sheet are painful to see grow when the building is underutilized.
Chicago is an outlier due to its inland location, but as the NYT points out, this sinking issue affects some of the most populated cities along the US East Coast. Climate change may be shifting how we work even more and disrupting the very nature of coastal cities.
February 20th and 21st - Commercial lending in trouble
Bad property debt exceeds reserves at largest US banks
European banks are playing for time on commercial real estate pain
From offices to malls to other types of buildings, companies simply aren’t paying their commercial real estate loans on time. Delinquent commercial property debt for the big six US banks tripled to $9.3B last year. What’s at stake here is the amount of loan allowances (or reserves) the banks hold to protect themselves and the broader economy. Typically, banks hold lower reserves for commercial loans than other types due to a consistent payment history. Yet, post-COVID, the world is anything but consistent. Delinquent payments, defaults, and low reserves make for a toxic combination, and ESG issues will only make it worse.
The FT got so close with this one but didn’t quite get to the connections with the previous points:
Some argue that relying on historical loss rates for commercial properties - particularly offices, in the wake of the Covid-19 pandemic may be risky, however, and that banks should instead be basing reserves on current levels of delinquencies.
That ‘in the wake of the Covid-19 pandemic’ line is doing a lot of work in the quote.
The following line includes a quote from (coincidentally enough) João Granja, an accounting professor in Chicago, who points out how high the vacancy rates are. Let’s look at the numbers.
In the spring of 2023, office vacancy rates in Chicago hit a record high of 22.6%. In Q4 2023, vacancy rates again hit a high of 30.2%. Vacancy rates in Q4 2023 for Manhattan sit around 22.8%. These numbers seem pretty serious, so if I could detract for just a second to address the CEOs of banks, who appear to be mitigating loan risk with employee policy:
You aren’t going to fix the brewing commercial real estate crisis by mandating a return to the office.
Meanwhile, these issues are already having ripple effects, with banks in the EU faring better than their US counterparts but not great. The second article, which covers the EU perspective on the US commercial real estate market, hits two ESG points well:
First, it recognizes the trend of working from home directly. The US seems to be staying remote or hybrid while the EU is more or less returning to normal, keeping vacancies down.
NOTE: I’m betting on more accessible public transport in the EU as one of the reasons, but that’s only my opinion, having spent years commuting via car.
Second, it calls out how “new ESG-compliant buildings” are in demand over their older counterparts. For those fans of TCFD, this sits squarely in transition risk. Modernized buildings fare better in the new world of ESG disclosures.
But ultimately, we arrive at a considerable financial risk. In the EU, “some €40B of European commercial real estate debt is expected to mature this year.” According to a CBRE report, $1.2T of global commercial real estate debt is set to mature through the end of 2025.
What’s next?
Who will pay off or refinance their loans, and who might use ESG factors to consider other options, including exiting or moving their physical locations? With delinquencies and defaults on the rise, we are already seeing the risks play out. If these trends continue, and there is no indication any of these trends will reverse in the near term, we will see more of this at scale through the end of 2025, with likely global economic challenges as a result.
There is another interesting point to consider. Private Equity firms have been famously snatching up housing over the past few years, with firms predicted to control up to 40% of the US market by 2030. What would happen if some of these distressed commercial properties suddenly became residential? It isn’t as far-fetched as you might think and could saturate the housing market, reversing housing price increases.
The commercial to residential is only one option being looked at. Another specific idea that has emerged is IKEA’s consideration of scaling across distressed shopping malls and going past the store into new experiences.
Solving this issue will likely take multiple strategies working in concert. Just as the risks are interconnected, the opportunities are as well.
Overall, the commercial real estate market is undoubtedly emerging as an interesting use case and argument for using an ESG mindset to see the more significant challenge. Still, I would feel much better if the stakes weren’t so high.
Does anyone else have that sinking feeling?