While political debates over climate change rage without apparent movement from either side, investors dealing in real estate are taking these risks more seriously. What’s driving these investors aren’t studies or scientific opinion. It’s more basic: a threat to margins.
Alarmed by the erosion of margins caused by climate-related events in recent years, investors in both REITs and equity projects have started including such risk into their investment decision-making process, in some cases leading firms to forgo investments in certain markets. There have also been measurable drops in valuations for entire regions.
A CDP report published last week showed a vast majority of companies across industries incorporate climate risk into their business strategy, estimating the costs of this growing threat at a trillion dollars.
Real estate is particularly vulnerable. A study published in the Journal of Financial Economicsin March concluded that real estate in areas prone to sea level rise already is selling at a 7% discount to comparable properties. And a 2018 study of coastal markets by the First Street Foundation, a nonprofit specializing in flood assessment, found that properties in the U.S. Southeast and the New York metropolitan area lost $7.4 billion and $6.7 billion, respectively, due to damage and valuation implications from sea level rise.
An increasing number of ESG fund managers and engagement officers are pushing REITs to add climate risk management to their evaluations of a project’s viability, according to a joint report from the Urban Land Institute and Heitman, a Chicago-based REIT.
This report quotes Mary Ludgin, Heitman’s head of research, saying the firm is not likely to abandon Houston, New York or even Miami in the near term, “but could and has caused us to opt not to buy assets with high exposure to environmental risks.”
Calculating this risk before committing money may sound like common sense. In fact, it’s a sea change for an industry that has not been out front on climate issues.
The new trend has cheered ESG fund managers who previously found that REITs and large real estate portfolio managers preferred to rely on insurance to hedge potential risks rather than calculate the potential hit to a project’s internal rate of return (IRR).
For both REITs and the hundreds of smaller groups that syndicate equity investments in multifamily real estate, getting these calculations right can be the difference between success and failure. For a multifamily project, for instance, projections of quarterly income from a 100+ unit rental apartment project are typically based largely on the difference between the cost of capital and existing operating expenses. Often, such projects also including funding to improve the property, thus adding to valuation before a sale seven to 10 years down the road.
It doesn’t take a direct hit from a mega-storm to squirrel those numbers. Heavy rains create complex new problems for drainage and waste water that can manifest hundreds of miles from landfall. Outdated urban infrastructure in many Midwestern U.S. cities and the loss of wetlands to agriculture upstream has exacerbated flooding along the Mississippi, Missouri and other rivers. Droughts in California, cyclonic storms on the Atlantic Coast, all have macro effects.
Now, as insurers, also begin to face climate realities, the idea of hedging downside risk with flood insurance is falling out of favor.
A 2018 study by climate consultancies 427 and GeoPhy cites the example of American Homes 4 Rent, a Maryland-based REIT whose Houston portfolio suffered more than $21 million in damage due to hurricanes Harvey and Irma in 2017. Insurance covered only $11 million of that tab. Whether insurance will even be available for some regions is in question. After Sandy in 2012, property insurers along the expensive New Jersey shore withdrew from the market entirely, though they have trickled back since federal and state insurance subsidies were augmented.
Given the quickening pace of violent weather, it should be no surprise that the numbers have finally forced the sector to take stock. Munich Re, a leading provider of catastrophic insurance and so-called ‘catastrophe bonds,’ says number of extreme weather events annually around the world has increased 250% since 1980. That has been a cold splash of water to the sector.
Again, it’s worth pointing out that much of this positive movement is being driven by risk-return calculations rather than any mission to ‘save the planet.’
And as major REITs and others in real estate increasingly face climate change, don’t be surprised to see a new greenwashed wave of enthusiasm for climate resilience in their marketing materials. Yet it’s better than the alternative.