Top 7 Reasons REITs Should Consider Climate Risk
In a high interest rate and expanding cap rate environment, real estate investment trusts (REITs) and other real estate investors must work harder for returns. One way that REITs can keep competitive is by leveraging location analytics to measure physical climate risk and resilience.
Physical climate risk refers to the potential damage caused by natural disasters such as flooding, wildfires, and hurricanes, whereas climate resilience refers to the ability of a location to withstand these types of climate shocks.
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 investors on the hook for the remainder. Acute weather not only results in costly property repairs but also disrupts the property’s business operations that support rental income. 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, increasing to 4 million days by 2051. For REITs, extreme weather represents a threat to net operating income because it results in costly asset repairs and downtime.
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. 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, investors run the risk of uninsured climate risk exposure over long hold periods.
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. For REITs with coastal residential portfolios, leveraging climate and location analytics can help them be more discerning within these markets.
4. Climate Migration Creates New Investment Opportunities
Climate migration is the relocation of people due to the environmental, social, and economic consequences of climate change and is already occurring all over the world. The Internal Displacement Monitoring Center predicts that approximately 14 million people will be displaced every year due to acute weather, and almost every region will experience climate migration – even in the United States.
For instance, the Center for American Progress conducted a study on migration patterns related to Hurricane Katrina and found that of the 1.5 million people who evacuated Louisiana, approximately 40% had not returned to their former residence after a decade, 15% stayed within 10 miles of their former residence, and roughly 10% relocated more than 830 miles from their former residence. The migration triggered by Hurricane Katrina serves as a poignant example of individuals moving out of climate stressed areas and into resilient ones permanently.
As people move the businesses that cater to them will also move – ushering significant amounts of capital into new geographies. As further substantiated in a joint report by the Urban Land Institute (ULI) and Heitman, as population dynamics change in response to climate, new real estate investment opportunities will present themselves, particularly in the locations that are best able to manage climate shocks. These locations will likely be characterized by having resilient infrastructure, strong public spending, and quality healthcare systems. Savvy investors can leverage climate analytics to take note of current and future migration patterns and capitalize on new investment opportunities.
5. Geographic Risk
The geographic concentration of a real estate portfolio is often measured at scale using the National Council of Real Estate Investment Fiduciaries’ (NCREIF) regional and sub-regional classification. Investors measure geographic allocation to ensure that the portfolio is weighted towards more productive regions without over-exposure to any single region. A useful extension of geographic concentration is climate risk concentration since tangential regions share many of the same climate perils. For example, NCREIF’s South region is high-risk for hurricanes, whereas NCREIF’s Western Pacific subdivision is high-risk for wildfires.
Regional Divisions & Climate Impact
6. Mark-to-Market Risk
Revaluation risk is highest during periods of market dislocation due to a change in operating fundamentals. Since REITs are publicly traded, the market valuation adjusts quickly to changes in investor sentiment. For example, in 2022 NAREIT reported that the public real estate index was down -24.9% driven by investor concerns about the future of office given low occupancy rates. However, it’s not hard to conceive that a similar mark-to-market might be triggered by repeated and severe weather events in certain parts of the world.
7. Climate-Related Risk Regulation
Globally, an increasing number of jurisdictions are introducing rules and taxonomies governing climate risk disclosures. In 2015, the G20 established the Task Force on Climate-related Financial Disclosures (TCFD) to provide guidance on how to disclose climate-related risks and opportunities to investors. Currently, TCFD is set to become regulation in the E.U., U.K., New Zealand, Singapore, Canada, Japan, and South Africa. Although TCFD is not currently required in the United States, it’s commonly adopted and incorporated into financial risk management practices. Globally, there have been efforts to standardize sustainability disclosure. Beginning In 2021 the International Sustainability Standards Board (ISSB) was established by the International Financial Reporting Standards (IFRS) Foundation to deliver a global baseline of sustainability disclosures. These rules were finally published in June 2023 and consolidate requirements between the Sustainable Accounting Standards Board (SASB), Carbon Disclosure Standards Board (CDSB), and TCFD. Standardization efforts underscore the growing importance of identifying, measuring, and transparently disclosing climate risk to stakeholders.
Moreover, global institutional investors require these climate risk-related disclosures from the companies and joint ventures they invest in. Therefore, REITs looking to attract capital from institutional players will need to have the capability to measure climate risk and location analytics can help them do so.
Overall, climate risk and resilience are important considerations for REITs that want to protect the long-term income and value appreciation while staying ahead of regulatory requirements. Reach out to our team for more information on how Climate Alpha can help you get ahead of the impacts from climate volatility.