Publications

- May 1, 2019: Vol. 6, Number 5

The megastorm era: Why the real estate industry is dragging its heels on pricing weather risk into values and investment assumptions

by Alex Frew McMillan

At one point this past September, the heavens became hell on earth. Hurricane Florence (pictured) roared ashore in the Carolinas with an unprecedented storm surge of 13 feet, then stalled, drenching the Eastern Seaboard of the United States with record, catastrophic rain of almost 3 feet.

At the same time, on the other side of the world, Super Typhoon Mangkhut hit Hong Kong with the greatest force on record, a banshee scream with gusts of 155 mph, with 60,000 felled trees reported.

Storms Barijat, Olivia, Isaac, Helene and Joyce joined the tropical-cyclone party, too, at the same time. The seven major storms developed separately, causing havoc for the Leizhou Peninsula in Guangdong, China; Hawaii; the Antilles in the Caribbean; and anyone stuck out in the north Atlantic.

Climate change is hard to track and prove precisely. The past five years have been the hottest in history.

Warmer temperatures mean higher sea levels, threatening coastal property and flood-prone geographies, meaning real estate bears the brunt of the physical destruction.

Real estate, however, also is the root cause of much of the warming. The construction and operation of buildings causes about 40 percent of worldwide greenhouse-gas emissions. Our cities also trap and retain heat.

Yet our cities continue to get bigger. Of the global population of 7.6 billion, 55 percent now live in cities — the United Nations expects that figure to increase to 68 percent by 2050. Through the middle of this century, India alone will add 416 million city dwellers, China will bring another 255 million, and Nigeria will add 189 million. Although much of the urban growth will come in smaller cities, 43 “mega-
cities” with at least 10 million inhabitants will exist by 2030. That’s a lot of concrete poured.

More people. More property. More storms. How can the real estate industry prepare its assets, through design or adaptation, for this new world of megacities and megastorms? How can property investors protect their portfolios in this new reality?

ASSESSING THE THREAT

The reaction of the real estate industry to climate change has been much like that of the rest of the world: slow and delayed. It may take direct impacts from natural disasters, whether to a building or the bottom line, for anyone to respond.

“Ultimately, it comes down to the belief in climate change from the fund managers and asset owners,” says James Fisher, the head of real assets at BREEAM. “Most likely, until a fund actually suffers a loss of yield as a result of a climate-change event, most will consider this something to take action on ‘in the future.’ ”

But a direct hit related to climate change does not simply trim a little yield off next year’s return; it is a catastrophic event. Macroeconomic forces may result in generally mild and gradual fluctuations of capital values and rents. Macro weather trends can result in the complete destruction of a building, or complete disruption to tenants’ operations and permanent loss of data. And that does not even factor in the human cost.

Fund managers are starting to consider climate change as a risk factor when they hold their annual buy-hold-sell asset reviews, according to Dan Winters, head of the Americas for GRESB, which benchmarks the performance of real estate and infrastructure assets on a variety of environmental, social and governance (ESG) factors.

“Portfolio resilience is a fast-moving topic,” says Winters, with returns exposed to physical, economic, social and regulatory pressures. GRESB is now offering a resilience module in its assessments, designed to identify and improve how managers approach the shocks and stresses related to climate change. The discussion is encouraging private equity managers to follow a framework of best practices, improve risk management and establish their track records on sustainability.

Investors and real estate managers are attempting to get an accurate picture of their exposure. Heitman, a property debt and equity investment firm, recently published the
Climate Risk and Real Estate Investment Decision-
Making
report in conjunction with the Urban Land Institute.

Laura Craft, Heitman’s head of global sustainability, explains the real estate industry now is devoting its time to modifying existing decision-making and management processes to tackle these growing challenges.

For now, managers are largely doing their own climate-risk analysis, if they’re doing any at all, and there aren’t agreed-upon metrics as to how or what they should be measuring. Heitman is using Big Data to map and measure climate risk. That information goes into investment assessment and, ultimately, to asset weighting in portfolios.

REIT EXPOSURE

The threat is not in a distant and ill-defined future. Globally, 35 percent of REIT-owned properties are already exposed to climate hazards, according to a report by property-valuation platform GeoPhy and the company Four Twenty Seven, which provides climate-change economic risk analysis for financial markets.

Making up the 35 percent are 17 percent at risk of inland floods, 12 percent in the path of hurricanes and typhoons, and 6 percent that stand to suffer from higher sea levels and coastal flooding. This is not theoretical risk due to climate or weather shifts: These properties have a high probability of experiencing “medium- to high-impact events”. They are being hit or are in harm’s way.

The funds based in Hong Kong and Singapore, two island city states, as well as Japan, are most in peril. Sun Hung Kai Properties, with $56 billion in property assets, has more than 25 percent of its properties exposed to seawater floods. Sumitomo Realty & Development Co., Mitsui Fudosan Co. and CK Asset Holdings — some of Asia’s biggest developers — have major climate-risk “red flags” on their properties.

The entire portfolios of 37 Japanese REITs, totaling $264.5 billion in property value, are exposed to typhoon damage and some of the riskiest storms globally. Typhoon Jebi in 2018 was the strongest to hit Japan in a quarter century, resulting in 480,000 insurance claims. It was one of nine major storms to hit Japan that year. In addition, permanent earthquake risk is another concern.

Climate change poses other threats to property. Extreme heat, drought, cold and wildfires are even harder to assess in terms of their ability to impair. Heat, drought and cold cause subtle long-term stress on individual properties, but they are less-related to individual, assessable events. If persistent, they can also drive down overall property values in a market and make it a less-attractive area in which to live and work.

Hurricane Florence in the United States affected the holdings of 94 different REITs. That encompasses 5,545 assets with 545 million square feet in aggregate. Another 2,900 properties and loans covered under commercial mortgage–backed securities were hit. Although direct damage is still rare, Hurricane Florence caused economic losses of more than $10 billion. A lot of those hit hardest were uninsured.

In the United States, the REITs with the highest exposure to flood risk are Vornado Realty Trust, Equity Residential and the holdings of Singapore fund CapitaLand. When Hurricane Harvey hit Houston and Hurricane Irma hit Florida, REIT American Homes 4 Rent suffered $20 million in storm-related damages to its residential holdings. After $11 million in insurance payments, it still took a $10 million hit to its bottom line.

FUTURE RISK NOT PRICED IN

Cities with easy access to the coast have appealed both economically for accessibility, and aesthetically for those great views, beaches and yacht berths. As a result, some of the world’s most-expensive real estate is directly under threat. Boston, Miami, New York City, San Francisco, and Tampa, Fla., are at great risk.

“We have already witnessed outsized increases in insurance expenditures in places like Houston and Miami, where climate change’s impacts are most obvious,” notes Darob Malek-Madani, head of research and analysis, and the co-author of a climate-change whitepaper, at property equity and debt investor National Real Estate Advisors.

But future increases in insurance are not currently priced into even the most vulnerable markets such as Miami, says Malek-Madani. Neither is the huge public expenditure necessary to upgrade and expand infrastructure, such as seawalls, flood channels, and raised, well-drained roads, to fight rising seas and combat larger storms. This government spending “will undoubtedly be funded, at least in part, by increases in real estate taxes,” he says.

That heightened cost of future tax and insurance premiums needs to be factored in when underwriting assets, notes Malek-Madani. For the moment, a best-practices manner of marking properties down for weather-related challenges has not been agreed to.

“Climate change will absolutely impair real estate values through operating-cost escalations, and likely also through cap-rate increases due to future risk,” he adds. “It would be ideal to be able to capture this future risk in current pricing, but we do not know a reliable way of pricing in climate risk today.”

WITHSTANDING THE IMPACT

It is increasingly likely investors and tenants will want to see real evidence that an asset can withstand the impact of changing weather patterns. In terms of mitigation, tenants and landlords will need to ensure their interests are protected enough to continue to operate even if conditions change.

“Real estate investment is all based around risk management,” asserts BREEAM’s Fisher. Climate change and business resilience are interlinked issues that now rank near the top of the list of key risks. An asset not built and managed to withstand this change is a greater risk to the investor, and “if not managed carefully, could devalue very quickly, wiping millions from asset capital values and rental yield,” he adds.

Should that factor into investment decisions? Currently, the transition to this way of thinking is at the early adoption stage. Economic consequences and equity impairments are only now being understood and assessed. Yet “stewards of capital,” in the words of Four Twenty Seven, have a fiduciary duty to clients and trustees.

BREEAM provides third-party sustainability assessments for property, and Fisher says the European and Asian markets are the most “engaged” in the concept to date.

French shopping-mall REIT Klepierre recently decided its whole portfolio of properties must commit to the BREEAM In-Use system, to give managers a better understanding of the environmental risks facing their malls. The system, which assesses a building’s operational performance by nine environmental factors, should help asset owners find ways to upgrade their buildings in ways that lessen disaster and weather-risk exposure.

The more-progressive managers at billion-dollar property funds are also talking about the need to “Paris proof” all the assets they own. This is shorthand for ensuring properties meet standards of the Paris Agreement and UN Sustainable Development Goals.

“This is an excellent way forward for fund reporting, as it is a concept that unifies us all and is very easy to understand,” says Fisher. “Ultimately, it is a simple measure of ‘Come 2030, will my assets and operation be fully sustainable?’ Having said that, we need to make these changes now, and not wait.”

WEATHER STATS AND RISK PROFILES

We are used to scary weather-related statistics, and there are plenty. In the United States alone, 1.9 million existing homes will literally be underwater by 2100, according to housing-data tracker Zillow Research, causing as much as $1 trillion in losses.

Global weather-related disasters cost a record $344 billion in 2017, the most-recent full-year figures available, according to a study by Aon Benfield. Weather-disaster insurance payouts were a record $132 billion. Properties exposed to sea-level rise are already selling at a 7 percent discount to comparable, less-exposed properties, according to a study by the University of Colorado Boulder and Pennsylvania State University.

Besides lower pricing, liquidity — no pun intended — may dry up in storm-drenched markets. Investors are likely to shy away from risky coastal areas to focus on inland cities, says Rick Kalvoda, senior executive vice president at real estate software provider Altus Group. Concern is also sinking in regarding inland cities with weather risk.

Heitman cites stats from a NCREIF and National Hurricane Center study that commercial property values in places hit by hurricanes drop 6 percent one year after the storm, and 10.5 percent two years later. While some long-term risks will be felt well after the end of an investment cycle, others can have immediate impact.

Investors are attempting to quantify the overall risk profile when underwriting and predicting the performance of an asset. Kalvoda would push for a catastrophe score to be included in any environmental checklist for properties.

These complications are creating new roles within companies and, beyond direct impact on price, are also adding to overall operational expenses. “The potential of extra underwriting would lead to a higher cost, resulting from a combination of increased personnel resources, fees for additional consultants and likely an extended due-diligence time period,” explains Kalvoda.

Institutional investors should have personnel designated specifically to sustainability issues, asserts Kalvoda. At GRESB, 90 percent of the 125 self-selecting companies that completed its resilience module have a senior executive responsible for the issue. That person often has the power to assemble a cross-department working group, set portfolio-wide directives and drive deployment of new information-based technologies.

MAPPING OUR SHARED FUTURE

ESG investing and standards tend to revolve around socially responsible investing. All too often, this conversation turns to flashy new buildings that are close to carbon-free and full of all kinds of green gadgets. That may be missing the point, both in terms of climate footprint and climate risk.

“Many of the issues stem from a very large number of existing assets that have had little or no attention when it comes to performance improvement,” explains Fisher. “In my view, it is better that 80 percent of the buildings out there improve by 20 percent than the other way around.”

Individual buildings can be toughened to resist high winds, power loss and, to some extent, flooding. Owners designing new buildings in riskier areas build with new threats in mind, allowing greater setbacks from bodies of water and incorporating storm-water management into building design.

Building owners can also mitigate energy- and water-supply risks by striking long-term contracts with their suppliers at fixed prices, hedging those risks, points out GRESB’s Winters. That offloads price volatility to a third party while also locking in supply to counteract future constraints.

Forward-thinking governments are refining zoning and building permissions. Tighter building codes can force change on the construction industry, with roofs, walls and foundations built to more-secure specs, and wind-resistance required of building materials such as concrete blocks and windows.

Severe weather has broad impacts on a community. Although 80 percent of participants in the GRESB Resilience Module assess physical risks, only 50 percent report tracking social risk and low-carbon-economy transition risk in any systematic way.

“A resilient building is worthless if the water-treatment plant is offline, or the transit system and roads are closed,” notes Malek-Madani. “We think the most-effective way to approach resilience is to focus on well-prepared cities rather than individual buildings.”

He would prefer to avoid high-risk markets such as Miami. When considering potential investment, National Real Estate Advisors would look to see whether a manager’s portfolio includes such markets, then whether the investor is accounting for climate change when underwriting new investments.

Winters agrees it’s not enough simply to consider building-specific issues. “Risk projections must include both a materiality assessment by micro-location, plus some probability of asymmetric impacts on the macroeconomic and operational supply chain,” he says.

Investors, developers and portfolio managers are beginning to do their own analysis of flood maps, sea-level projections and geographic information system (GIS) data. Companies such as Four Twenty Seven and GeoPhy, which specialize in applying Big Data techniques to analyze and assess property-portfolio impacts, are springing up.

Winters notes leading private equity fund managers are mapping their portfolios with geospatial tools to assess their risk factors, perform sensitivity analysis, and then modifying the discount rates they use. They are also factoring in climate-related data to their 10-year pro forma projections.

Heitman’s Craft believes a set of “best practices” will emerge. Investors will get better at reporting risk and using Big Data to identify patterns in asset liquidity and value. The insurance industry will need to communicate better on how climate change is affecting premiums and coverage. Local municipalities and regulators will need to set standards and ensure transparency.

The Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) notes investors may not be able to avoid climate-related risks. Switching from one asset class to another will eventually cease to work, as a wider scope of assets feels the effects.

The TCFD cites a study that suggests both the importance and the great uncertainty of corralling climate risk at this stage. The value of the global stock of manageable assets at risk now through the end of the century is so huge as to almost be unknown; estimates range from $4.2 trillion to $43.0 trillion.

Although we know greenhouse gases are increasing in a linear fashion, it is becoming increasingly clear climate change is charting another, accelerated course. How fast that trajectory turns out to be will account for the price we all will surely have to pay.

 

Alex Frew McMillan is a freelance writer based in Hong Kong.

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