Heitman’s Craft: Managers need to better understand climate risk

For Laura Craft, global head of portfolio sustainability strategies at Heitman, climate risk was not on the radar of many real estate managers five years ago.

“We found that many were just beginning to think about the physical climate risk within their portfolios and beginning to think about how they map that risk,” said Craft, speaking about the first climate risk report that the Chicago-based manager published with the Urban Land Institute in 2019. By the time the follow-up report came out a year later, many of those firms had mapped their portfolio for climate risk.

What has created greater urgency around understanding climate risk recently, however, is the spike in insurance pricing, which has occurred since multiple insurance companies have pulled out of states such as California and Florida over the past year.

“I think insurance could be one of those shocks and stressors that, as an investment manager, if you haven’t taken this seriously, this could make you take it a lot more seriously in certain areas where there is a tremendous amount of risk,” said Craft, whose firm published its fifth climate risk report with ULI late last week.

In Heitman’s own case, the manager saw an insurance quote rise dramatically over a period of a few months while it was underwriting assets last year. “So you have to think about your underwriting,” she noted. “It’s not just the insurance that you’re getting now, but what is it going be over time, and do you have acceptable insurance that you can get to protect your property?”

At the same time, it is not possible to underwrite what an insurance company will do in terms of coverage or pricing in the future.

“Insurance is a one-year bet and real estate is a longer bet,” she said. “We’re betting on five, 10 years and we’re selling to other institutional investors for another five or 10 years.

“We have to take a longer term perspective than insurance companies because they can reprice it annually. So, that’s where the burden of understanding the true risk to our portfolio falls on the investment manager.”

Rising insurance costs have affected some of Heitman’s decisions to invest in assets. “What we try to do is price climate risk into the deal,” Craft said, explaining that the firm looks at the underwriting assumptions – including insurance and operating costs over the holding period, as well as exit cap rates – in order to do so. “So we haven’t necessarily shied away from areas, but we are trying to price it in,” she added. “We look at the asset level risk, we look at the market level risk and we look at portfolio level risk.”

Moving the needle on disclosure

Although it is difficult to estimate the percentage of managers making climate risk disclosures, Craft points to a June 2023 National Multifamily Housing Council study that revealed more than 58 percent of respondents did not use risk management software, which provides organizations with real-time data on various types of risks.

However, “two things that are going to move the needle are investors and regulations,” Craft said. For example, in the US, the SEC has proposed regulations for mandatory climate reporting for all public companies in alignment with the Task Force on Climate Financial Disclosures, which consists of 21 members across the G20.

“It’s likely that if investors start getting access to that data, whether you’re public or private, they’re going to ask for that data,” she remarked. “I think a lot of this is going to come from an investor push to understand, has the investment manager that they placed money with, have they truly assessed the risk within the portfolio? Are they future-proofing the portfolio against these risks?”

Standardization, however, remains a challenge for climate risk data. “A lot of the data providers that we use for physical risk, they’re assessing the location for flooding risk or sea level rise risk or hurricane risk,” Craft noted.

“But what they aren’t assessing is the underlying property. So has the property mitigated such risk? Is the property built elevated above the flood risk? Has the building been built in recent years up to the newest and latest building code that helps protect against wind damage, for instance?”

She is hopeful that regulations will help to drive more standardization of data. If a reporting framework like the TCFD is in place for a long enough period of time, “then it becomes the standard for how investors ask” questions relating to climate risk, she said.

“What investment managers need to do is really understand the climate risk within their portfolio, have an understanding of how they’re managing it and being able to report on it,” Craft said. “I think if you’re able to do that, then you’re going to be in a better place to respond to any regulations that may come through or any investor requests about these topics.”