Climate change headlines have been difficult to escape in the last year; whether the wildfires in Australia and California, flooding in Venice and the UK or typhoons in Japan, evidence of extreme weather and other natural disasters was everywhere.
Climate risk, however, is not an issue that is front-of-mind for many in private real estate, based on conversations PERE had with more than a dozen sources. In fact, Egbert Nijmeijer, co-head of real assets at Amsterdam-based manager Kempen Capital Management, estimates only 20-30 percent of the industry is incorporating climate risk into their underwriting. That percentage, moreover, is overwhelmingly composed of managers and investors with a long-term investment horizon, he says.
“I see a relationship between the time horizon of investors and the amount of underwriting that they do on this topic,” says Nijmeijer. “The shorter the time horizon, the less people are inclined to take this into consideration.”
The common belief among short-term investors that “you can get out in time” is a miscalculation, however. Nijmeijer asserts: “What if the future buyer starts underwriting risk? You may be selling at a loss, depending how quickly the market changes.”
“It starts to become a game of musical chairs if you take it to its logical conclusion,” agrees Greg Lowe, head of sustainability at Aon. “It’s actually a really important thing to recognize you may be a short-term investor, but the person who’s buying this from you might be thinking about climate risk. They’re going to be thinking about how the person they’re selling it to in three to five years is going to be viewing this.”
Mary Ludgin, senior managing director and head of global research at Chicago-based real estate investment manager Heitman, adds: “There are many in the industry that are saying, ‘It’s not happening on my watch.’ But no one knows when there will be a shift in either investor sentiment, or the sentiment of the insurers. The potential for a shift represents a risk.”
What is clear, however, is that sentiment is shifting as climate events continue to make headlines. “What we have seen is the pace of climate change has accelerated if you measure it from the melt of polar ice caps, sea level rise and other dimensions, that along with the ferocity of storms that are being experienced,” she says. “We can only anticipate that leads to more incidences that then help shape perception of risk, and that ripples through to valuation and potential for liquidity.”
When asked how often managers are factoring this risk into their investment decision-making, Derk Welling, senior responsible investment and governance specialist at Dutch pension fund manager APG Asset Management, responds: “Not enough yet. I still come across some managers who underestimate the potential impact. We’re looking far more ahead and see potential risks where managers probably don’t see the risk. That’s not good stewardship for what we’re aiming at.”
He points to one of APG’s investments in the state of New York, which passed a net-zero carbon law last year with specific building emissions targets for 2024 and 2030. “There was an asset that was below the 2024 target, but it was above the 2030,” he says. “The manager told us, ‘By then we will have already sold the asset.’ But my question then was, ‘But your future buyer will look at the 2030 targets.’” This has led APG to take a more conservative approach in its underwriting and calculate with more conservative numbers than the manager does, he says.
However, Ludgin says the industry’s climate risk awareness has grown significantly in the space of one year, as exemplified by the audience reception to two climate risk presentations she did at Urban Land Institute meetings in January 2019 and January 2020: “In that time, the awareness of this as a risk, or as a set of risks, had experienced its own J-curve.”
Ludgin notes that at the January 2019 presentation “the senior-most members of firms seemed to be saying, ‘That’s for somebody else to worry about; it’s not part of our hold period.’” This year, however, “they were eager for more conversation about this pressing topic.”
Worries over ongoing insurance coverage has been one reason for the shift in mindset, she says: “The insurance side of it is one of the first ways that climate risk could affect the value of a building. If you can’t insure it, it makes it unsaleable, and for people that think that they’re protected because they have insurance, then there’s this recognition of ‘wait a minute, my insurance contract is a year.’”
Rising costs have also been a wake-up call for the industry. Indeed, US property insurance rates have been increasing for 10 consecutive quarters since Q4 2017, following Hurricanes Harvey, Irma and Maria, according to Kevin Madden, real estate practice leader at London-based risk, reinsurance and healthcare services firm Aon. This 10-quarter streak follows 17 quarters of rate reductions from Q3 2013 to Q3 2017, he says.
The rate increases, moreover, have shot up in recent quarters. In the US, the quarterly year-on-year change in the average rate was 21.4 percent, 28.6 percent and 24.5 percent during the second, third and fourth quarters of 2019, respectively, according to a Q4 2019 Aon report. By contrast, the average rate rose 11 percent, 4.3 percent and 4.5 percent, respectively, during the same quarters the previous year, the report stated.
“It’s almost a global event right now of rising insurance costs,” he notes. “The numbers are going up for two reasons. Storms and water damage, flooding and various other catastrophic losses, they are becoming more frequent and more intense. [Second,] the values at risk have just grown exponentially; a hurricane that may have hit 50 years ago, if it hits the same location, the loss is significantly higher because there’s more value at risk.”
In fact, the period from 2010-19 was the costliest on record for global natural disasters, according to Aon’s 2019 Weather, Climate & Catastrophe Insight annual report. Total direct economic damage and losses for the decade came in at $2.98 trillion – more than $1 trillion higher than the previous 10-year period, the report stated.
“The rising insurance costs are absolutely hurting the net operating income of a real estate asset, and, as we know, valuation of a real estate building is tied to the NOI,” Madden adds. For example, for a property that is being underwritten at a 5 percent cap rate, $100,000 in increased insurance costs will result in a $2 million reduction in value, he says.
Many property investors are failing to fully comprehend the extent of increased insurance costs, which include not only rising rates but the “hidden costs” of rising deductibles. “Underwriters continue to push deductibles up – for a windstorm, a hurricane, they push the deductible anywhere from 2-5 percent,” Madden says. “So, if you’ve got a property that’s valued at $50 million, you’ve got a $1 million deductible at 2 percent. That’s a sizable deductible the property has to absorb.”
Meanwhile, “many insurance companies are de-risking and reducing their exposure to catastrophic wildfires, hurricanes, flooding, etcetera,” he says. “They feel that the current premium levels do not support the risk.”
As insurance coverage becomes more limited in certain markets, remaining insurers can charge more, which can lead to higher insurance costs than what was originally underwritten, Ludgin adds. These increased insurance costs will come on top of unanticipated higher operating costs that could result from greater heating or cooling needs and property damage from climate change-related events such as flooding or extreme weather, she notes.
Ludgin believes the globe’s major cities, most of which are located on, or near, bodies of water, will be made more resilient through infrastructure projects such as elevated roadways or sea walls. But those infrastructure costs will be borne at least partly through higher property taxes, which will be another unknown for real estate owners in those markets, she says.
“So, all of a sudden, you’ve got three costs that vary widely from your underwriting,” Ludgin says. “And if we’re at this late cycle where a lot of assets are priced to perfection, those three blows are what nobody wants.”
A costly transition
Higher insurance rates, operating costs and tax bills are all tied to the physical risks associated with climate change. Yet real estate owners also face unexpected cost increases arising from transitional risks, which relate to policy or technological changes associated with low-carbon emissions targets set by federal and local governments. For example, the Paris Agreement intends to keep the global temperature rise this century to well below 2 degrees Celsius and aims to limit the temperature increase even further to 1.5 degrees Celsius, while 19 cities globally have committed to achieve net-zero carbon emissions in new buildings by 2030 and for all existing buildings by 2050.
“Investors need to recognize that they’ll be forced to reduce the emissions at the building level and bear the costs associated with that, which they may not have underwritten,” Ludgin says.
Sasha Njagulj, global head of ESG at CBRE Global Investors, recalls the risk management program the firm put in place after the UK government first announced Minimum Energy Efficiency Standards regulations – which mandates that all buildings have a minimum energy performance certification rating of E to be rented – in 2013. After evaluating its UK portfolio, which included assets that did not yet have EPCs, the firm conducted on-site energy assessments, assigned ratings to assets and made improvements to the properties that fell short of the minimum required grade.
“We needed to de-risk the portfolio ahead of the regulation coming into force in 2018. In case of F- or G-rated assets, there was often expenditure required to bring them in line with the new standard,” she recalls.
However, real estate owners must contend with a regulatory environment that is constantly in flux in the effort to combat climate change, Njagulj says: “Now the UK government, with a new commitment to being net-zero carbon by 2050, is talking about a more stringent MEES regulation, so again we are going to the next cycle of improvement, to an even higher standard.”
Policy changes, along with physical climate risks, therefore, can have a negative potential impact on property values, according to investment research firm MSCI. “While in the near term, valuations may be more significantly affected by physical risks than policy risks, potential costs were highly sensitive to policy changes,” ESG researchers Linda-Eling Lee, Meggin Thwing-Eastman and Ric Marshall wrote in a January report.
In a United Nations Environment Programme Finance Initiative pilot project, the aggregate gross asset value at risk for a $78 billion test portfolio with nearly 1,000 assets was estimated to be -1.9 percent under a 2 degrees Celsius climate scenario and average weather-related damage to the underlying properties.
Even as climate risk becomes a greater threat across the globe, most managers and investors have not ruled out environmentally vulnerable property markets. BentallGreenOak, for example, currently is in the process of acquiring new assets in Miami. “There’s no question that Miami is at greater risk because of rising sea levels,” says president Sonny Kalsi. “But we really focus on the micro-locations within cities.”
The office property that the firm recently committed to buying in Miami, for example, is located in the city’s downtown, rather than on the beach, making it less exposed to sea-level rise. The expected exit pricing was also a factor: “We basically put a premium on the cap rate, on the asset on the going in and, actually, on the going out, because we felt that whoever is going to buy this asset is going to want a premium to what they would want if that asset was located in [a city like] Austin and Nashville.”
BentallGreenOak also continues to purchase properties in Japan – which accounts for 60-70 percent of its investments in Asia – because of resiliency measures that have been implemented in the country. “Japan is more geographically vulnerable to earthquakes and typhoons, which could lead to flooding,” says Kalsi. “That being said, it’s also got some of the most advanced infrastructure in the world.” Tokyo, for example, has constructed sea walls to protect the city from typhoons and tsunamis, and has building codes to ensure properties can withstand earthquakes and potential climate change risks.
In Australia, severe drought conditions have not kept QIC Real Estate from amassing a sizable retail and office portfolio in the country. However, the Brisbane-based manager has devised ways to adapt those assets to extreme weather. “There’s not many parts of Australia not subjected to dry conditions on a regular basis,” says Michael O’Brien, QIC’s global head of real estate. “What we’re seeing is that the issue is becoming more pronounced on an annual basis.”
In the face of such conditions, QIC has made water storage an important focus, installing water tanks under car parks during major expansion or development projects and harvesting the resource during short periods of intense rainfall in the country. “There’s a lot of work we do around ensuring we build as much climate resilience as we can at the start, because it’s obviously much harder to then go back in and retrofit assets,” he says.
In other cases, climate risk has led managers and investors to rethink their investment approaches in certain markets. Kalsi notes his firm previously had owned hotels on Miami Beach in the early 2010s but has more recently passed on similar investment opportunities. “Prices have gone up a lot and we did not have as bullish a view on the market as to what sellers were expecting in terms of their pricing,” he says. “But number two, we had a much bigger concern. After Hurricane Irma, a big chunk of Miami Beach was underwater. The streets had a couple of feet of flooding. It made a big impact. That combined with the pricing expectations gave us second thoughts.”
BentallGreenOak also has become more cautious about buying real estate in higher-risk flood zones in New York City.
“I wouldn’t say we’ve gone so far as to redline them, but it has made it prohibitive for us to buy anything there,” says Kalsi. “For example, if the mechanical systems haven’t moved from the basements to the middle of the building, or optimally on the roof, it is so expensive to move them that you can’t afford to buy them … It doesn’t make economic sense for us to buy it and then add that on top of the cost of the acquisition unless we can get the seller to help effectively subsidize that.”
Kalsi says his stance on climate risk has evolved from just a few years ago, when it was not considered a high priority for his firm. But this risk factor has risen in importance for a number of reasons. “First of all, how climate change impacts our real estate investment thesis is now a bigger deal,” he says. “There’s a much higher degree of heightened sensitivity around it. Number two, it’s gone from something that you wanted to maybe do to now being something that makes good business sense. Then number three, for investors, it’s become much more important.”
Although climate-aware managers and investors remain in the minority in private real estate, he believes bigger managers will lead the way for smaller firms. “One of the challenges is it’s harder for smaller managers to have the resources and time,” says Kalsi. But some of those firms will make climate risk a priority and ultimately will develop strategies to address the issue, while others will be pressured by their investors to do so.
Against this backdrop, he believes climate risk will show up on the radar of most private real estate players one way or another: “People don’t have a choice. You’re not going to be able to ignore this.”
The climate data conundrum
Reliable information is critical in addressing climate risk. But current data and models on the topic are lacking
Even among the climate-aware in the private real estate industry, making investment decisions relating to climate risk is far from a straightforward process. “In general, the real issue here is availability of climate impact data is limited around the world,” says Egbert Nijmeijer, co-head of real assets at Kempen Capital Management. “The different data vendors that have specialized in this topic, they use a lot of model assumptions to get to their climate scores, because any hard data in a consistent way measured is not really available.”
However, “it’s important for everyone to take a step back and understand which tools answer which questions, because there’s a lot of technical nuance here,” says Greg Lowe, head of sustainability at Aon. Aon, for example, advocates a value-at-risk approach, which determines what the cumulative financial impacts of different climate hazards could be. Other common modeling approaches, such as mapping and risk rating, are useful but not necessarily well-suited for financial decision making or applicable to real estate clients, he explains.
Lowe adds: “By using the wrong approach and not necessarily understanding the limitations of modeling, that could also lead to potentially negative outcomes where people are relying on data where they don’t understand the assumptions and the models and you start to make the decisions that may not be the right decisions to make.”
Then there is the question of how reliable the data actually is. “These global models also must be handled with great care, as not all of these models really come up with forward looking climate risk data,” says Derk Welling, senior responsible investment and governance specialist at fund manager APG Asset Management. “You cannot simply extrapolate a risk from the past to the future when it comes to climate change because these events will happen more exponentially.”
APG conducted a test where it asked six global data providers to perform a physical risk assessment for a specific asset in the Netherlands. What was problematic, however, was one data provider determined the asset had a high flood risk in its assessment, while another firm came up with the opposite assessment, even though both data providers had used the same data source. “The selection of these global data providers is a risk in itself,” says Welling. “There’s still a lot of room for improvement.”
Sasha Njagulj, global head of ESG at CBRE Global Investors, meanwhile, says it is difficult to determine precisely what percentage of her firm’s portfolio has a ‘high’ exposure to climate risk. That is largely because there is no consensus in the industry on scenario analysis and benchmarking of climate change risk, as the many different climate models and tools available in the market are either too narrow in focus or otherwise lacking in meaningful information.
“At the moment, there is simply not a single, generally accepted benchmarking tool that does everything,” Njagulj notes.
Not yet awake on climate risk
The real estate lending community has yet to incorporate climate change into loan risk assessments
When it comes to issuing loans in the US, banks and mortgage companies are focused on appraising the credit quality of the borrower. “Nothing in those appraisals touches on physical climate risk at all,” says Stacy Swann, chief executive and founding partner of Washington, DC-based Climate Finance Advisors. “You don’t have anybody incentivized at the moment to think about climate risk as part of an asset risk. And then, mortgages in this country are sold on the secondary market pretty quickly, so those underwriters don’t actually hold risk for very long. That’s also a disincentive for them to integrate a physical property risk assessment around climate hazards.”
A risk assessment for a loan typically covers counterparty creditworthiness, the asset value, the economic situation and the revenue stream for the property. “What you really need to do is infuse into that risk analysis a measure of climate-related risk,” Swann says.
Although climate awareness is currently lacking among lenders, Swann expects banks and mortgage companies to follow the lead of insurers on risk exposure. As more companies shift their coverage out of property markets that are exposed to certain climate risks, “then you’re going to start to see lenders wake up,” she says. “You may also start to see some lenders move out of certain geographical markets.”