How Climate Risk Impacts Commercial Real Estate Lending

Climate risks have made it hard for commercial real estate developers to decide how to finance certain commercial projects, how to predict how climate change will affect real estate prices, and what, if any, changes to make to their businesses going forward. 

In this article, we will discuss how climate risk impacts commercial real estate lending, why mitigating climate risk is important to the lending industry, the different ways of reducing climate risk, and the role of commercial money lenders in mitigating climate risk.   

Climate Change Risks

Climate risks are the risks associated with the effects of climate change. The frequency and severity of natural disasters in the country and the world have increased significantly in the past decade due to climate change. Naturally, natural disasters come with severe damage, and lives and properties are lost. The damage caused by natural disasters is often tremendous, and people and places often never recover from them. The effects of climate change cut across different sectors, and commercial real estate is not left out.  

Climate-Related Financial Risks

Climate-related financial risk is the event that may occur as a result of climate change. It may influence different financial institutions, both public and private, and usually in a negative way. Climate change is a huge threat to the economy. Now, more than ever, financial institutions are preparing for the worst and including clauses that will cover expenses and protect revenue in the event of climate change-related issues.  

The commercial real estate lending industry is not excluded from taking measures to prevent the aftermath of climate change from wreaking havoc on their finances. The limitation, however, is the uncertainty of climate change. Money lenders may not know exactly how to weigh an event that is not entirely predictable and provide adequate risk cushions for it. More research needs to be made on climate change and how it can directly affect commercial real estate, the areas that are more likely to be affected and what specific damage can be done.  

How Does Climate Change Affect Commercial Real Estate Money Lenders?

Several issues affect commercial real estate today, and climate change is one of them. Here are some ways climate change affects commercial real estate money lenders. 

Loss of Revenue

The money lending industry can be severely affected by climate change. The drastic effects of climate change may lead to a loss of investment income on the part of the lender.  

Assets Loss

Assets are vital to any commercial real estate money lender. This is because, often, borrowers use these assets as collateral for loans acquired from lenders. The effects of climate change could lead to a total loss of assets. Flooding, for instance, could destroy properties and render them totally or partially useless. This great damage to properties will set the lender back by a lot of dollars.

Assets’ Value Drops

An effect of climate change is a drastic reduction in the value of assets. When this happens, the lender suffers a considerable loss. As was stated earlier, the effects of climate change are a threat to virtually every sector, and every industry is taking measures to protect itself from the harsh effects of climate change. 

While the effects of climate change are general, the real estate industry definitely will be on the receiving end of many losses due to how closely related the environment and real properties are. The adverse effects of climate change can in no time render a high-profile property pretty much invaluable. It could also overturn the fortune of an area in no time. For instance, a highly coveted high brow area will soon become an avoided area should natural disasters begin to happen there often or the weather condition becomes unbearable. This will undoubtedly affect the price and value placed on such properties since the property’s value is no longer consistent with the value at which it was bought. This poses a huge financial loss for the parties involved.  

The commercial real estate lending industry is starting to factor in climate change risks, and they include it in their underwriting decisions and agreements. Lenders are making provisions for climate change risk to prevent suffering huge losses or to provide cushioning should they lose money or assets eventually.  

The Importance of Mitigating Climate-related Risk

Mitigating climate-related risk is just as important as mitigating every other risk for commercial real estate money lenders. The goal is the same: to manage risks so well that losses are prevented.

Money lenders generally work with assets. As mentioned earlier, the adverse effects of climate change could lead to a loss of revenue and total loss of assets. Another impact of climate change is that it could reduce the value placed on assets. When the value of assets reduces, it reduces the chances of the lender making a profit off the investment and may cause him to lose his capital.

What Can Lenders Do to Protect Their Assets?

As scientists continue to warn about climate change, many financial institutions are starting to put certain principles and rules in place to protect their assets. Commercial Real Estate money lenders are also doing what they can to mitigate the risks that come with climate change to protect their investments. Below are ways money lenders can reduce climate change risks.  

Climate-related Risks Must be Treated as Financial Risks

Climate-related risks need to be recognized as any other financial risk and treated as such. When climate-related risks are taken with as much seriousness as any other financial risk, it becomes a lot easier to cushion the effects of climate change-related risks.

The Borrower’s Asset Must Be Thoroughly Assessed

A lender must ensure that the borrower’s profile is appropriately assessed and checked for climate-related risks. Just as the borrower is checked for other risks like capacity, collateral, and capital. The lender must ensure that the collateral and the project to be embarked on are not at risk of being affected by adverse climate change conditions.

Climate-related Risk Integration Tests

Lenders must actively carry out tests concerning climate-related risks before lending money to borrowers. An example is structural test to get research results on properties to be purchased and ensuring that they are not vulnerable to natural disasters caused by climate change. The test must be conducted properly to avoid unforeseen future situations. 

Piggyback on the Efforts of the Government

Generally, the government makes laws on financial risks to avoid loss. Lenders can always rely on these laws as a proactive step to reduce climate risk.  

Portfolio Diversification

A lender can reduce climate-related risks by diversifying his portfolio. This simply means that the lender invests its revenue in different assets. It may also be referred to as spreading out investments. The primary purpose of spreading out investments is to reduce risks associated with a particular class of investment. 

Roles of Commercial Mortgage Lenders in Mitigating Climate Risk

More Education

Mortgage Lenders must educate themselves properly on climate change and speak to experts. This must be done to know how best to protect investments and what kind of projects to supervise.  

Including Climate Risk Clauses in Loan Agreements

Climate change risk clauses must be included in loan agreements to safeguard money lenders from risks associated with climate change.  

Conclusion

In conclusion, given the obvious physical manifestations of climate change, it will be inadvisable for any sector not to protect itself by coming up with novel and growing ways to mitigate the risks associated with climate change.  

Now more than ever, lenders must be careful to ensure that they do not suffer losses due to not paying enough attention to climate-related risks. Lenders can avoid future risks by entering their lending criteria and having the system automatically look for deals that meet those criteria. With the FL marketplace, you will be able to see all the details of every deal in the market, so you can confidently make a competitive quote. 

Finance lobby is a marketplace that connects lenders to brokers and ensures that both parties meet their unique needs. The advantages of using a marketplace like ours is tremendous. You do not have to go through the strenuous process of looking for either a borrower or a lender. Finance Lobby does that for you. Click here to get started! 

September 12, 2022

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