← The Sustainability Story
The Sustainability Story
Daniel Warcholak, CFA: Understanding Climate Risk in Mortgage-Backed Securities
00:35:23
Loading summary
Transcript29 lines
- [00:00]
A
Foreign.
- [00:04]
B
Hi everyone and welcome to the Sustainability Story Podcast. This podcast explores critical sustainability issues and trends on a global scale. I'm Nicole Garrick, Director of Global Industry Standards at CFA Institute and one of three co hosts for the Sustainability Story. I'm excited to have Daniel Warschallic, Head of Capital Markets for Basis Investment Group with me today and we're going to discuss climate risk in mortgage backed securities. Today, Daniel leads the capital markets trading and securitized products initiatives at Basis Investment Group, drawing on over 25 years of experience in securitized real estate, debt investing and management. He previously spent 17 years at CW Capital Investments where he chaired the Investment Management Committee and oversaw portfolios exceeding 10 billion. Earlier roles also include senior positions at Crummy May and John Hancock's RMBS MBS subsidiary. Dan is both a CFA charter holder and a cpa, and he also serves as co Chair of the External Relations Committee for the CFA Society of Washington, dc. Dan, welcome. It's great to have you here with us today.
- [01:24]
A
Thanks Nicole. It's my pleasure. And thank you for inviting me to the podcast. Look forward to a good conversation here today.
- [01:31]
B
Great. So to kick things off, I'd love to hear about your personal connection to sustainable finance. While I know that sustainability isn't the central focus of your current role, could you share how ESG factors and stable sustainable investing have influenced your career over time and maybe what experiences or moments shape your sustainability story?
- [01:54]
A
Absolutely, yeah. The whole issue of sustainability and, you know, issues around climate and so forth is very important to me and to firms that I've worked with. And you know, I think for me it really started around 20 years ago when Hurricane Katrina hit in 2005. And it's interesting that we're speaking now on essentially the 20th anniversary of this event. But the reason it started for me there is, you know, the firm that I work with at the time, we were an investor in subordinate debt from commercial mortgage backed securities, basically the subordinate bonds. And what that means is that we own the credit risk in these pools. And so we're directly exposed through our fixed income investments, are directly exposed to the commercial real estate properties. And when Hurricane Katrina hit, it did tremendous damage. It was, you know, 125 billion in damage. 1392 people lost their lives. And it created a, a massive event in the, you know, through New Orleans and the whole area. And we had properties that were in that area that were impacted directly. Not only, you know, the, the personal cost from the people, but from a real estate perspective, which is what's backing Our bonds, our mortgage bonds, that had a major, major impact because those properties were closed, they were severely damaged and so forth. And at the time we happened to be in the middle of a merger transaction and it really, it sort of stopped everything in its tracks while people went to evaluate, you know, what impact it had ultimately on our portfolio. So needless to say, it really got my attention and it made me appreciate and understand the exposures and the potential risks that are created by these type of events. And you know, on an ongoing basis, we continue to see these events, you know, sort of ramping up over time. And as an investor in the space, we're really, I think of it as basically on the front lines of this, you know, of this, you know, of these events. So that's why it's such focus and importance to me.
- [04:17]
B
Yeah, thank you so much for providing us some of the insight and really how climate change has become more relevant to your investment role and really how the Hurricane Katrina was pivotal moment in kind of reshaping your thinking about how risky, like you said, how you're on the front lines on how sustainability can impact capital markets.
- [04:39]
A
Absolutely.
- [04:40]
B
I'd like to dive into the discussion now on climate risks and I'd like to ask you how you define climate risks in the context of commercial mortgage backed securities or CMBS portfolios.
- [04:53]
A
Yeah. So climate risks and how they impact over time, they're, they're really, I think of it, you know, really in, in three ways, which, which I'll talk about. And one is, you know, obviously the physical risk to the properties that back our securities and you know, what we own because we're essentially a lender, we have those properties behind it. Whenever one of these events happens, you know, again, it's, it's, it's a potential impact to us and it could ultimately impact the investment performance. So that's one, the physical risk. The second is transition risks. And as we transform to a greener and more sustainable economy, this also has an impact for commercial properties and for the viability of those properties on an ongoing basis. And the third is what I would consider to be insurance risk. And the insurance risk is because the properties are basically insured, there's, you know, from time to time there could be a gap in your coverage, there could be a gap in the events that happen. And overall the insurance is, since there have been so many events over the years, it's getting more and more expensive at the properties. And so those really three risks, the physical, the transitional and the insurance, are kind of how I start to frame, you know, how we think about it, the reason it becomes so important now. Okay, And I go back to Katrina as the first, you know, attention getter for me. I just look at how these events, these, you know, billion dollar disasters have unfolded over time and since, since, you know, 2005, over the past 20 years. And what I can tell you is that in 2024 there were $27 billion events, okay, that hit, that's basically a 10% growth rate from 10 years ago. And each year that sort of keeps getting more and more intense. And the, the dollar amounts are, are higher and higher each year. And as that intensity builds, this is a risk that you cannot ignore in your portfolio. And this is data that comes from NOAA or the national oceanic and Atmospheric Administration, NOAA for short. They publish great information about this and you can look at charts and you can see from 2005 to 2024, you, you can just look at the ramp up in what they're simply tracking is the number and the cost of these events that are at least a billion dollars worth of damage. And so you know that that has to be an attention getter for us. And so that's why we focus on this, on this issue so much. Transitional. The second one, you know, that I mentioned, this is more, you know, the cost of doing something at your property to make it more efficient and to bring it in into whether there are additional regulations which come to play or whether or not you just want to make it a greener and more efficient property. There are costs associated with that. That's a risk in the portfolio. And then insurance, as I mentioned, in the last four years we've crossed $100 billion for the third time. And that's a material number. I mean you can't ignore that. And that filters through to the cost of coverage at your property and your ability to maintain insurance and the level which is maintained. So it becomes a real risk that you have to think about in a very clear way. You gotta really look.
- [08:53]
B
Yeah, that NOAA Data is staggering. $27 billion vets, that's huge. And with such a rise in extreme events, it's clear that physical risks of climate change have definitely impacted your industry. And as you said, something you need to focus on and be aware of. Could maybe you describe how transition risks have impacted the industry.
- [09:18]
A
Yeah, so transition risk is kind of like that next level, aside from the really obvious. So let's say that you moving greener, whether it's through your own interest, whether it's the market demand or Whether it's regulated, it costs, there's additional costs to it. Right, because obviously you're looking at constructing a property from maybe materials that are more efficient and sustainable. You're looking at things like LEED certifications, which can. They bring a number of issues or a number of potential factors into getting LEED certifications. Water efficiency, heat and electricity efficiency, you know, walkability scores. I mean, all sorts of factors come into that. And that, you know, compared to not doing any of those things, it can cost a little more to do it. I've looked at some studies that suggest that it could be 3 or 4% higher on new construction to take just basically measures which make these buildings and use. Let's use LEED as a, you know, as our, as our benchmark here to bring them into at least some type of certification level. But you know, it is a cost. It's something that we have to think about. But you know, I've looked at several studies which show that buildings which are certified and which do have a green type rating, they actually Command up to 31% rent premiums compared to buildings which are not. And when you control for location, because you have some, some cities and some locations which have higher concentrations of LEED certified properties than others, even when you control for that, if you look over anything that's been constructed within the past 10 years, that rent premium is still, you know, 14, 14%. And that rent premium is a significant factor in performance of the property and that a better performing property is obviously a less lower risk for us and a better property to be thinking about buying a bond which is backed by that property. You also have more demand. It's been shown through a couple of studies that I've looked at, there's probably 4 to 5% higher average occupancy at LEED certified buildings compared to non LEED certified buildings. And so you start to see that the investment in something that is, could be considered in the transitional area like I. E. We have to make it certified or make it green. That investment actually produces savings and produces a better property, I think, for you. And it produces a more, you know, it's, it's properties that people want to be in. There are better spaces. They're, they're newer, they're more efficient. You know, the people that are in the properties have better economics on just simply being a tenant and they're better properties overall. The risk in portfolios, in bond portfolios is that you typically when you buy a pool which is backed by these, you also have properties that are not certified or have not made the investments in these type initiatives. And so if you have a holding period, if your average bond is backed by a 10 year maturity mortgage loan over that 10 years, that property could really become, you know, kind of like a stranded asset at some point if the market continues to want to move to more efficient and better properties. You know your risk as an investor in this and something that we think about is, you know, how's that going to impact us when we get 10 years down the line and this property has to be refinanced or sold? Is it going to continue to trade at a premium or at some type of level compared to all the other properties in the portfolio? So it's something we really have to think long and hard about.
- [13:25]
B
That's great, that's very informative and a lot of good information on transition risks in regards to lead buildings and how you think about those types of investments. So it sounds like the market is rewarding sustainability with kind of these premiums for the LEED certified buildings.
- [13:46]
A
I think it is rewarding certainly for the certified buildings. And I think, you know, even we at basis we moved to a LEED certified building about a year and a half ago and we're very proud of that. You know, what we've done is, you know, we've gotten into great, great sustainable property. So we're very happy about that. You know, when we think about investments overall, the market does reward, I think it does reward investments which have these have made the efforts and have the certifications and it's a better property. And I think the properties that are not, again, you still can continue to have those as part of your portfolio. But I think you might think slightly differently about the risks associated with them. You know, when we're acquiring, we might assign a potentially higher lost severity at some point just given the volatility and the possibility when you get 10 years down the road, five or 10 years down the road, that you'll be facing stiffer competition in terms of comparable properties.
- [14:52]
B
Right, yeah, no, that makes sense. Like you said, giving a higher default probability for those non LEED certified buildings that are in a pool makes sense.
- [15:01]
A
Yeah, exactly.
- [15:02]
B
Can you share a case where climate risk materially impacted a CMBS either positively or negatively? You don't have to go into too much details on the specific property, but can you give a scenario for our audience on how they should think about that information and how it's used?
- [15:24]
A
Yeah, so, absolutely. So the way I think about this, you know, how does it really impact your portfolio Is it really, you know, these events, I would call them, you know, unanticipated or unscheduled events that happen. Right. I mean, no one knows when or where you know, something is going to hit, but you, you might have exposure to it. It's really, it's manifested in two ways in the portfolio. And we're, we're as subordinate bond investors where you could think of us as credit investors. So that's one aspect is the actual credit. So that's why, you know, we're highly, highly focused on that. The second is just simply from a cash flow predictability standpoint. And if you think about your bond, you may ultimately have a property which goes through some type of event and then gets liquidated, you know, because it's, you know, the debt remains there and so that adjusts the cash flows in your, in your bonds. Now that can happen. And it, it ha. I know it's happened across the industry. We've seen examples of hotels, for example, that might be in an area that's directly impacted by a hurricane. And those hotels could be closed and highly damaged for long periods of time. And typically businesses, whether it's a hotel or other businesses, carry business interruption insurance. So that allows their loans to continue to be paid while there's some type of disaster event going on, that is if they're closed. But if that insurance is shorter than the time period that it actually takes to get that property reopened, that becomes a credit issue for you. And that happens. I've seen properties that have been just flat out knocked over by events and that happens. And so that's why again, these risks really get into the portfolio and have to be, have to be thought through pretty carefully. One other way that, you know, I think about how climate or how these events and exposure to these events impacts the portfolio is through just simply through the credit of the underlying properties. And if you just look at insurance, insurance and taxes, as a result of what's been happening over the past several years, those insurance premiums have grown exponentially. Okay, let's just say exponentially. Certainly in risk based areas. Taxes, real estate taxes are also growing exponentially because the local municipalities are faced with massive, more and more massive cleanups and people ultimately have to find a way to pay for those things. And so that goes through your property. If you think about any property, $1 of extra cost in a property that falls straight through to the net cash flow at a cap rate can have an impact of about $12 on the value, the actual value of the property. So there's a multiplier effect that takes place as you have these ramped up costs. There's actually a multiplier on the value of the properties. So again, going back to my example of having a 5 or 10 year investment bond investment that's backed by a 5, 5 or 10 year loan, if you have those costs building over time, you might have thought that you had a property that was a 70% loan to value whenever you, you bought the pool. But you have to account for those incremental costs over time. And that's something we have to factor into our analysis now as to how that increases over time. Because all things insurance alone could ultimately cause the cash flow to decline significantly over time and it could ultimately cause the value of the property to decline. And with the same loan amount, you might be looking at a 85% loan to value, which is a different risk profile than what you initially thought of. In addition, your coverage on your loan, your debt service coverage ratios might go from, let's say maybe you had a 150, 160 cover. Now you might have a 130 or 140 cover. So it's a riskier loan, it's a riskier property. And that's, that's assuming that nothing, nothing actually no physical event happens to the problem.
- [20:07]
B
Nothing happens. Yeah. Cause then it's even worse. Right.
- [20:10]
A
Nothing happens. So, and then when you, when you build all those factors together, what that does is that changes the risk profile. It basically makes your portfolio more volatile. Right. And you have to be able to anticipate and think about what those risks are and then price accordingly whenever you're making your investment decision upfront. So that's just some of the ways I think that it ultimately impacts, impacts our portfolios.
- [20:37]
B
Great, thank you for those examples.
- [20:39]
A
Sure.
- [20:40]
B
So we've, we've talked about climate risks showing up in these real world examples. I'd love to shift gears and explore how you actually integrate those risks then into your investment process. So for our audience, this is where frameworks and data really come into play. Can you maybe provide us some information on some of the frameworks and methodologies and data that's available to help integrate some of these climate risks into an asset manager's investment process for this specific asset class?
- [21:11]
A
Yeah, absolutely. It's something that I think about all the time. And it's like, how should we be evaluating this? And you know, know, how do we think about it? Because we really have to look forward, you know, five to ten years when we're, when we're Making these investments and think about what can happen. You know, the first thing, the first piece of information is going to be disclosures that are out there. And if you're buying a bond, you're, you get an offering memorandum and you get what's called an annex A, which in the case of CMBS bonds, it, it details know lots and lots of data points about the properties. And in there are disclosures about whether or not a property is in a flood zone, for example, and flood zones are expanding every day. Right. It's just given what's happening, you have to know if your property's in a flood zone or not. You might want to look at whether or not you're in one of the earthquake zones. I think three or four. It is, you might want to look at, you know, phase one environmental reports for your property. I mean, was your, was your property, you know, was, was your property formerly a dry cleaner that used a lot of chemicals on the site and now you're going to be financing. You want to test to make sure that none of those things are in the immediate area of the properties. And so that just from a disclosure standpoint, that's, that's one area where, where we would start. Second, for data purposes, again we would just review events that have happened at the various properties. Things that we know about obvious risk areas. We might look at some data tools that are out there. You know, I know there are data tools which compare metropolitan statistical areas or MSAs based on economic factors. And included in those analysis, included in those specific tools would be things like the, you know, some type of scoring related to the environmental and like NOAA event risks which we talked about earlier and that's built in to that data. So we might look at that, that kind of information and those kind of models to help us better understand the area. We'll also look at flood zone maps, ratings, actual risks around the properties and think about, you know, that kind of information as well. And that's generally accessible. There are things that you can find. But here data that we use because we're in a first credit position, we really get into the nitty gritty at the property level. So when we're looking at buying a bond, we actually have people who will go and visit, physically visit the properties. And a pool can be, you know, these days there aren't as many properties and pools that there were at one point, which is great because it allows you to, it's a, you know, it arguably is as diversified, but there's, it's more manageable so we have people that will go and actually look at the properties, understand them, you know, do a physical site inspection. Then we'll, we also would engage with the sponsors and we might ask about any programs that they have at the properties. Are you, are you guys certified? Are you lead certified? Are you moving toward that? Are you making improvements to the property which will help it to remain competitive in the marketplace? Given what we talked about earlier, I mean do those, you know, because we again, we think those are, those are generally better properties in the way market is going. We might ask them for their business plans and overall we might just, you know, try to help raise awareness of the properties of these things and try to help borrowers ultimately to, or not borrowers or owners who are borrowers to best manage the properties. Because our, our, our risk is, you know, their risk is our risk. Right, because we were a lender on it. We might go and score the investments then and we'll review, you know, any third party information that's available. We'll look at the, the certifications, we'll look at walkability scores, we'll look at any other risks associated with the properties and the borrower's plans to implement all of those particular pieces. So there's a lot of data that is out there and it depends on where you're invested in the risk profile. If you're equity, even if you're a direct lender, you're going to have access to a lot of specific information about it. But there's a ton of market information as well. You know, I talked about, you know, some of the tools that are available, there's lots of data sources also are out there, but really the disclosure is kind of the place to the place to start with all of that.
- [26:17]
B
It sounds like reviewing disclosures and engaging with sponsors are key ways for investors to better understand the climate risks associated with their investments. And as you mentioned, by working with the property to enhance the sustainability of their properties, both parties can benefit from higher rent premiums and increased occupancy rates while also reducing transition risk exposure. Additionally, there's a growing opportunity in climate conscious investing. Financial incentives like green credits and alternative financing structures are driving market changes. I would like to explore how these tools, including green credits, are being used to support sustainability. Can you maybe explain what they are and how they're being used in the market?
- [27:12]
A
Yeah, absolutely. This is, there are a couple of incentives that are in the marketplace again because, you know, we think that undertaking these efforts is, is really, it's an investment in your property. Which I think has returns to it. And I think we. We talked earlier about, you know, the benefits of rent premiums. We talked about the benefits of occupancy. And some, some areas where we can really quantify it. Nicole, as you mentioned, are, you know, we're also. We're a lender on the properties, and we lend through the agency. And I know that one of the agencies, Fannie Mae, I think, offers credits, green credits, for properties which meet certain standards. If you are in a Group 1 green building certification, I think the current rate is around 15 basis points. Where you're financing, essentially it's a credit that goes against the rate. So it's kind of. It's a reward for meeting these particular certifications. There's a Group 2 certification, I think that's 20 basis points. And then if you. And they have certain criteria in each, you know, including, you know, minimum standards that have to be met. And then there's something that's called a toward zero green building certification, which is really quite a lot of efforts that I think is about a quarter point in benefit to your loan rate. When you talk about, you know, multifamily loans, you can talk about loans that are 20, 30 million dollars. And those kind of basis points on those loans really translate into major, major benefits for borrowers. And then ultimately it's a better property, it has more favorable financing, and that I think that benefits everyone. So that's a very nice program. And it's an area where, you know, we're seeing those efforts rewarded. Specifically, there's another area that I'm aware of, and it's CPACE financing. And cpace financing is specific financing that's available for improvements to the properties. And it's not. You kind of have to think about it in terms of debt, but it's not a, you know, a mortgage loan per se. It's financing that comes onto a property for the purpose of rehabs for upgrading to energy efficient, you know, heating, cooling, you know, water efficiency, efficient materials, you know, more, you know, friendly materials, other infrastructure. And the important thing about the cpace financing is it's actually. It becomes an assessment on your real estate taxes as opposed to, let's say, a loan payment back to the bank. So there are tax benefits to having this as an assessment on the property over time as opposed to having it as a specific mortgage loan. But it's a nice program. And I think it's not everywhere, but I think there are many states and local municipalities that offer that type of financing. And I know that there are several companies out there which specialize in cpace financing. So I would encourage anyone that's interested in that to look, look it up and you'll have a lender that'll be able to help think about those initiatives as well. So they're very positive signs if you think about it. You have these kind of rewards. These are actual basis points off tax advantages to being responsible. Just in addition to what I talked about earlier is several studies show those rent premiums and you know, higher occupancy rates overall. Because that's, that's what, you know, I think the way the market is moving and I think there are lots of rewards for that.
- [31:12]
B
Thank you so much for providing us with that information. So we've covered the risks and green incentives that are really shaping the market. We're about out of time. But I'd like to just ask one last question for you on lessons that you've learned on integrating climate risk and what advice you would give to other investors in the space.
- [31:33]
A
Sure. Yeah. So I go back to the, to, to my attention getter. Okay. Which was that, that Hurricane Katrina when it, when it really had such an impact and it made me think about the risks that are there. And again that's, that's a specific event. But as these multiply over the years, the, the, the events just get more and more, you know, come to the forefront. So I think like just kind of look at the data that's out there, you know, and think about how these things are actually impacting your portfolio. And it's not specifically, it doesn't even have to be a specific property that you think about. You might be an investor in some area that has general economic exposure to a metro area which gets, you know, hit by some, some climate related, you know, issue. And that, that's going to have some impact on your portfolio. Whether it's businesses being closed for much longer than anticipated. It's going to be businesses that just flat out go away. It's going to be, you know, other issues. It's going to be insurability in the markets. There are just multiple impacts from these things that I think people don't, you know, I think it requires careful thought about how it impacts your particular portfolio. And again, depending on where you're an investor, if you're at the highest level, let's say you're a securitized investor, you're a bond investor, if you're at the highest level, you could end up with prepayments when you didn't expect them. You could end up with all sorts of, you know, events there. If you're deeper in the credit stack, you could end up with, you know, actual credit events that you have to think about. And if you're in the equity, you're certainly, you know, going to be thinking about those risks. I, I've also learned to look for the gaps, not not only the events, but to look for the gaps in what you assume is covered. You assume, you know, if you have some type of risk that, oh, sure, this is, you know, the municipality is going to take care of this and it's going to be on their dime. It's going to be insurance, it's going to cover it, it's going to be someone else. But look for the gaps because they're there. And you have to understand how that's ultimately going to hit your portfolio. And then, you know, finally, I think that there's just, there's no downside to doing this and taking these initiatives. And I just look at the, the properties and the performance and just the efforts and what we think are just better outcomes. Whenever you undertake efforts to make things more sustainable. And I think that impacts whether you're an investor in equities, whether you're a property owner, whether you're a bond investor, I think those risks are there and I think there's real upside to anyone, even at a personal level, to being environmentally responsible.
- [34:41]
B
Great. Well, thank you so much for joining us today and sharing your insights. You've given us a comprehensive look at how sustainability is shaping the future of securitized real estate debt. We've learned how environmental risks are being assessed and mitigated and how different incentives like green credits are helping drive positive changes. So, again, thank you so much for your participation and your insights shared today and I look forward to working with you again in the future.
- [35:10]
A
Nicole, thank you for the opportunity. It's my pleasure and talk to you anytime.