In a high interest rate and expanding cap rate environment, real estate investors must work much harder for returns. One way that investors can keep competitive is by getting better at assessing and managing physical climate risk within their portfolios.
Physical climate risk refers to the potential damage to properties caused by natural disasters such as flooding, wildfires, hurricanes, and extreme temperatures, all of which are becoming more frequent and severe due to climate change.
In today’s challenging market, leveraging data to gain a deeper understanding of climate risk and resilience may be the difference between an accretive or non-accretive investment.
1. Direct Damage from Extreme Weather Each year extreme weather causes billions of dollars of damage to the real estate industry. In 2021 the world’s largest reinsurer, Munich Re, incurred $120 billion of insurable losses, representing the second most costly year on record. However, insurable losses represent only a small portion of total losses, estimated to be $280 billion, with real estate owners and investors coming out of pocket for the remainder.
Acute weather not only results in costly property repairs but also disrupts the property’s business operations that support rental revenue. A study performed by First Street and Arup estimates that flood damage to commercial buildings in 2022 resulted in 3.1 million days of lost business operations, which will increase to 4 million days by 2051.
For real estate investors, extreme weather represents one of the largest threats to profitability, with the potential to wreak havoc on both top and bottom-line revenue.
2. Rising Insurance Costs & Reduced Coverage Although insurance rates are rising nationwide, the increase is most significant for property owners in climate vulnerable states like Florida and Texas. For example, insurance companies hiked premiums for commercial properties in Florida by 15%-30% in 2022, with additional hike rates upwards of 50% expected in 2023. Given that premiums are adjusted on a yearly basis, the compounded cost of rate hikes can put substantial pressure on net operating income, a key valuation metric for real estate investors.
Moreover, insurance companies have already begun to limit coverage or decline to renew policies in high-risk areas. This will drive not only how people live, but where they live. For example, after the California wildfires in 2018 and 2019, insurers dropped coverage for many homeowner policies. Since the amount of insurance available for a property can change on an annual basis, real estate investors run the risk of uninsured climate risk exposure over long hold periods.
“Real estate is no longer guaranteed to go up and to the right. Climate change combined with other macro drivers such as interest rates and disruptions like demographic shifts and remote work heighten the need for deep, data-driven research and robust scenario planning to pick the winning locations of the future.“ Parag Khanna, CEO of Climate Alpha
3. Coastal Market Devaluation
There is growing evidence that climate risk in coastal markets, which are susceptible to storm surges and flooding, has already affected residential real estate prices. More specifically, a 2018 study performed by Pennsylvania State University and the University of Colorado indicated an average 7% “sea-level-rise discount” for non-owner occupied coastal residential properties. Similarly, First Street Foundation released data showing that eight states lost a combined total of $14.1 billion in coastal home value since 2005 due to sea-level-rise flooding.
4. Climate-Related Risk Regulation Globally, an increasing number of jurisdictions are introducing rules and taxonomies governing climate risk disclosures. In the United States, the Task Force on Climate-related Financial Disclosures (TCFD) and the Task Force on Nature-related Financial Disclosures (TFND) are two frameworks that provide guidance to real estate investors on how to disclose climate-related risks and opportunities.
The TCFD was created in 2015 to help companies disclose climate-related risks in their financial filings, whereas the TFND was launched in 2021 to help companies disclose impacts on a much broader basis, including biodiversity and other key aspects of nature, covering land, ocean, freshwater, and atmosphere. As of now, TCFD and TFND are not required by law, but are increasingly adopted by investors as best practice. Moreover, some large institutional investors are beginning to require these disclosures from the companies they invest in.
5. The Rise of ESG Motivated Capital ESG investing has gained significant traction and is on its way to becoming a mainstream investment. According to the Global Sustainable Investment Association, ESG assets surpassed $35 trillion in 2020, up from $30.6 trillion in 2018, representing one-third of global assets under management. At this pace, ESG assets could exceed $50 trillion by 2025. Data from Morningstar also shows that global sustainable fund flows hit a record high in 2020, with net inflows of $152.3 billion, underscoring high demand for sustainable investing.
As an ESG alternative, climate resiliency is more quantifiable than most ESG strategies, and therefore less susceptible to greenwashing. As such, investing in climate resiliency represents a unique opportunity for real estate investors to take advantage of capital flows while boosting returns through enhanced portfolio risk management.
Overall, considering climate risk is important for real estate investors who want to protect the long-term income and value appreciation while staying ahead of regulatory requirements. For more information on how Climate Alpha can help you get ahead of the impacts from climate volatility reach out to our team.