In September, as the US city of Houston was still reeling from the destruction of Hurricane Harvey, news emerged that Brookfield Asset Management had struck a deal to buy the Houston Center, a 4.2-million-square-foot office complex in the storm-ravaged city.
Despite the catastrophic hurricane, however, the Toronto-based alternative asset manager did not have misgivings about proceeding with its acquisition.
The company is no stranger to owning properties in markets that are vulnerable to extreme weather. In the Houston area alone, the Toronto-based alternative asset manager already owns another office complex, the Allen Center, as well as five malls through its subsidiary GGP. And while Houston was getting hammered by Harvey, the city of Mumbai, where Brookfield purchased a 4.5-million-square-foot business park last year, was also enduring its own monsoonal flooding in August.
Then there’s Brookfield’s office properties in downtown New York. “We’re used to dealing with extreme conditions,” says Brian Kingston, chief executive of Brookfield Property Group, of the company’s large presence in Lower Manhattan, where its real estate business is based and which was one of the areas hardest-hit by Superstorm Sandy in October 2012.
But extreme weather has picked up in both force and frequency in recent years, with four major hurricanes – Harvey, Irma, Jose and Maria – wreaking havoc during the months of August and September. In fact, Harvey ranks as the second costliest natural disaster in US history, with an estimated $81 billion-$108 billion in property damage and economic loss, according to a report from commercial real estate services firm CBRE. The storm falls behind Katrina in August 2005, with $160 billion in damage, and Sandy, with approximately $70 billion in damage, the report said. A separate CBRE report pegged the estimated economic loss from Irma at $25 billion-$45 billion.
Meanwhile, record-setting heat, drought and strong winds have led major wildfires to break out across parts of California, Oregon and Washington in recent months. In California alone, the fires are forecast to have a total economic cost of more than $85 billion, according to weather media company Accuweather.
“I would definitely say that it’s more prominent in our thinking than it has previously been,” says Kingston. “There’s always been natural disasters, but certainly the number and scale of them in the last few years seems to be greater, and as a natural consequence, it gathers more discussion.”
Weather and natural disasters ranked as one of the top 10 risks among real estate owners in 2017, according to a report from London-based risk, reinsurance and human resources firm Aon. A quarter of respondents reported losses from such a risk and 45 percent said they had put disaster preparedness plans in place.
“They’re starting to ask the questions and make it part of their due diligence process,” says Kevin Madden, head of Aon’s real estate practice. “Five years ago, not as much. But I think Sandy was a big wake-up call for them in New York and Harvey will be a wake-up call, and Irma will be a wake-up call for doing the due diligence on the resiliency of the property.”
RISE OF RESILIENCE
Within a real estate context, the concept of sustainability is slowly evolving from solely focusing on energy efficiency and reducing greenhouse gas emissions to also addressing the threats brought upon by extreme weather. “Sustainability will gradually expand from a focus only on the management of a building’s ‘carbon footprint’ to include the inevitable consequences of climate change,” LaSalle Investment Management wrote in a June report. “It will be prudent for property investors to anticipate that severe weather – high winds, flooding, higher heat and droughts – will occur regardless of humankind’s success or failure in reining in its impact on the natural environment.”
Resilience strategies include installing impact-resistant glass that can withstand hurricanes and tropical storms; extra on-site and backup power capacity; moving a building’s power center to an upper floor or rooftop to protect against storm surge; and landscape features that provide natural barriers and buffers from sea-level rise and flooding, according to a 2015 Urban Land Institute report.
“Sustainability considerations and weather-related risks are taken into account throughout the investment lifecycle – from investment sourcing to property management,” says Abigail Dean at London-based real estate investment manager TH Real Estate. “For example, we select sites and design roof and façade systems to minimize vulnerability to catastrophic events. This results in real-time strengthening of a building and reduces repair costs and potential business interruptions for tenants in the case of an event.”
Meanwhile, Brookfield largely avoids making macro-level assessments in markets vulnerable to extreme weather. “The reality is, it becomes more bottoms up,” Kingston says. For example, downtown Houston, where the Houston Center is located, generally suffered less damage in the storm than the city’s energy corridor. Meanwhile, the business park in Mumbai is located on a more elevated part of the city, Kingston notes.
While the specific location within a flood-prone market needs to be considered, so does the specific asset, he adds: “In our due diligence, we spend a lot of time with our operating teams, assessing building structures, safety systems, and generally how resilient the asset will be on the assumption that if you’re in these markets, there is going to be extreme weather from time to time.”
Aside from physical upgrades, enhanced communications are also critical to improving the disaster preparedness of properties. Brookfield, for example, has an app that allows the company to disseminate emergency communications to its staff and tenants. During Harvey, Kingston was able to not only get updates on the company’s assets from Brookfield’s team in Houston, but also have all of its local staff and tenants accounted for during the storm. Disaster preparedness – including the ability to communicate en masse – became a critical issue for Brookfield after 9/11. “Coming out of that, there were a lot of learnings,” says Kingston.
By the time disaster struck again in Lower Manhattan with Sandy more than 10 years later, Brookfield was ready to take the hit, with backup generators set up to produce the electricity required to allow for the continuity of operations. “I think Brookfield Place was the only building south of 14th Street that had power throughout Sandy, and I think a lot of that was due to good preparation in advance,” he says.
In addition to ensuring business continuity, the resilience of a building also protects the value of the asset, Kingston adds: “If we’re able to get that water out in two days rather than having to scramble around and find pumps, and it takes you two weeks, the difference in terms of the economic loss you’ve got there is very, very significant compared to the cost of being prepared.”
MAKING THE RETURNS WORK
Neither Harvey nor Irma are expected to have a significant overall impact on the Houston and Florida commercial real estate markets, respectively, with residential properties having suffered the brunt of the destruction, according to the CBRE reports.
“I don’t think we had any damage anywhere that will even reach the limits of the deductible in our insurance,” says Kingston. “We’re not worried that these events that we’ve seen this year are going to have a material impact on the returns for the assets.”
Jacques Gordon, global head of research and strategy at Chicago-based real estate investment manager LaSalle Investment Management, notes that the potentially high insurance cost on an office building in Miami can currently be offset by the lower insurance costs of other assets if the Miami building is incorporated into a broader diversified portfolio covered by a national insurance policy. Provided insurers continue to cover flood-prone markets like Miami, those cities will continue to attract investment, he says.
However, “one of the bigger long-term issues is that certain properties in certain areas simply become uninsurable, because the risk is too great or too unpredictable because of climate change,” says Alex Bernhardt, head of the US responsible investment team at New York-based consulting firm Mercer. “There are plenty of scenarios where we can see that manifesting over a long enough time horizon.” Ultimately, such scenarios could lead some investors to pull out of certain markets. “If there’s a greater return potential as a result of that greater risk, then maybe investors will persist,” he says. “But if not, then it could result in investors divesting.”
In the more immediate term, Kingston expects hurricane and flood insurance to become more expensive as a result of the recent storms. “You’re certainly going to build that additional cost in,” he says. “And all of those costs around emergency preparedness, whether it’s equipment or otherwise, gets factored into the expense line of the underwriting and therefore you need to make the returns work.” For example, if Brookfield were evaluating two similar-quality buildings, one of which was in a high-risk market and the other in a low-risk market, the property in the high-risk market would need to generate more income to offset the greater risk, he says.
Although extreme weather is less of a driver of investment decisions than other factors in a particular market, like strong demographics, “it does certainly factor into your thinking as to the costs we’re going to face in the future, whether it’s insurance or operational, or even just thinking about potential cleanup costs following future disasters that might happen,” says Kingston. “No question, I think it has an impact on value.”
For Gordon, the risks of investing in a flood-prone market include higher insurance costs, lower liquidity, less rent growth, slower leasing activity and more cap-ex dollars needed to climate and disaster proof a building.
“You expect a higher return and therefore a higher yield in a market that has these risks,” he says. “Your entry yield needs to acknowledge that your exit is going to be more difficult.”
While it is a risk that is “very much in the background” in many markets, extreme weather becomes one of the top three issues in locations like Miami, he notes. Still, the initial step in an underwriting process remains putting together an effective bid to tie up the property. The due diligence on a property, including climate-related risks, is done as the second step in the underwriting process, he says.
“We like to get paid when we invest in Miami for the additional risk,” Gordon says. Compared with the expected return in a core gateway market, “you want to see a 50 basis points or greater difference to compensate you for all these uncertainties.”
Gordon, however, believes that while the recent hurricanes may be a rude awakening for some property owners, such firms may not necessarily improve the disaster preparedness of their portfolios.
“Yes, it’ll be a wake-up call,” he says. “And then what’ll happen is people will roll over, as they’ve done many times, and go back to sleep.”
REACTIVE NOT PROACTIVE
Property owners haven’t been doing enough to safeguard their real estate assets from climate-related risks, agrees Aon’s Madden. “We’re starting to see it happen, but not at the pace it should be … Unfortunately, the real estate industry is reactive and not proactive on issues like this.”
He expects the adoption of resilience measures to follow a similar path to that of the green building movement. “The real estate industry was slow to respond to that,” Madden notes. It was not until tenants started asking for green buildings that property owners began to focus more on sustainability efforts. Similarly, with extreme weather, “it goes back to the tenants, because the tenants are going to ask, ‘What’s the chance of this building being flooded?’”
Institutional investors have also taken steps to examine climate-related risks within their own portfolios, and in turn could compel managers to do the same. For example, the New York City Pension Funds hired Mercer in February to “determine how to incorporate the realities of global warming into the Funds’ asset allocation, manager selection and risk management processes,” according to a statement at the time.
“They should certainly be asking managers how they think about climate change risk and what they’re doing to address environmental risks in their portfolio – what their contingency plans and business continuity plans are,” says Bernhardt. “They’re very important questions to be asking, and if you’re not getting satisfactory responses to some of those questions, then that’s a red flag, for sure.”
Meanwhile, Madden believes local authorities and lenders alike could hold real estate owners more accountable, by requiring them to have a resiliency plan in place in order to proceed with a project or have flood insurance in order to get a mortgage. Indeed, disaster preparedness on a state level, including enhanced building codes, evacuation and contingency plans and heavy investment in pump systems, helped to minimize damage on Florida’s commercial properties, according to the CBRE report.
Gordon concurs that cities and regulators can play a crucial role in reminding real estate owners of the importance of preparedness. “Memories can be short in all kinds of crises,” he says.
STUDIES IN RESILIENCE
Some private equity real estate firms that have adopted resilience strategies have seen a beneficial impact on returns
Project: 6 New Street, Boston. Developer: Gerding Edlen
Resilience features: Elevated building systems above the floodplain; limited entrances on the waterfront; ground-floor protection by curb wall and planters
Resilience costs: Minimal additional cost above typical development costs
Resilience returns: $9 million+ in avoided losses; lower insurance premiums; $150,000 annual energy savings; 2-18 percent rental premiums
Project: Ritz-Carlton, Grand Cayman. Developer: Five Mile Capital Partners
Resilience features: Upgraded generator; flood control measures; restored mangroves
Resilience investments: $3.5 million, including future mangrove restoration expenses
Resilience returns: $300,000 annual energy savings; protection against storm damage; enhanced property value