How Investors Can Address Climate Risk in Real Estate
Climate change has led to an increase in the frequency and severity of extreme weather events such as hurricanes and wildfires, and these catastrophes are expected to impact the world for years to come. Climate risk, which refers to the hazards associated with climate change, can significantly threaten real estate portfolios, as it disproportionately affects coastal gateway markets such as New York, San Francisco, and Miami.
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Institutional investors and real estate investment managers must evaluate the increasing significance of climate risk given the material financial impact that climate change can have on real estate portfolios.
The Task Force on Climate-related Financial Disclosures defines two broad categories of climate risk: physical risk and transition risk.
- Physical risk refers to potential property damage that can be caused by climate change, and it can be further categorized as acute or chronic. Acute physical risks are event-driven and are associated with extreme weather events such as hurricanes, flooding, or wildfires. Chronic physical risks are related to long-term shifts in climate patterns such as the increase in global temperatures, which can lead to rising sea levels, extreme heat, and drought.
- Transition risk refers to the changes in policy, technology, and market dynamics that result from the transition to a low-carbon economy and that can impact the outlook for an asset or sector.
Some real estate investors argue that climate change will not affect their assets in the near term, and that they will be able to sell the assets before material climate change impacts are observed. However, these investors fail to consider that future buyers may begin to incorporate climate risk considerations in their underwriting, as climate risk can directly impact the volume and reliability of future cash flows (i.e., net operating income). Specifically, there are four climate-related costs that some investors already consider in their projections:
- Insurance premiums: Insurance coverage for assets in vulnerable markets has already begun to reflect the impacts of climate change-related weather events through increased premiums, higher deductibles, or reduced coverage. Insurance is generally considered the primary protection for asset values, but it is important to note that while insurance can protect an asset from physical risks, such as hurricane damage, it does not offer any protection from transition risks (e.g., the potential illiquidity or reduction in value as hurricane-prone markets lose favor with tenants and buyers).
- Operational costs: The rise in global temperatures can result in extreme heat in certain areas, leading to increased cooling costs for property owners. Additionally, extreme weather events may also cause property damage, which can lead to additional operational expenses for repairs.
- Capital expenditures: For both existing buildings and new developments, property owners may look to implement preventative measures such as flood barriers or storm drainage systems to protect assets from damage incurred during climate events.
- Real estate property taxes: Local governments in vulnerable markets may look to invest in protective infrastructure to limit physical risk and improve resilience in the face of potentially catastrophic events. This will likely be funded by an increase in property taxes.
While investors cannot completely isolate their real estate portfolios from the impact of climate change, they can and should take a thoughtful approach to managing climate risk in their portfolios. Institutional investors should urge investment managers to consider climate risk by mapping geographic exposure to vulnerable markets and implementing plans to address and mitigate climate risk concerns for the most at-risk properties. We expect more real estate investors and investment managers to incorporate exposure to physical and transition risks at an asset- and portfolio-level as a part of risk management, in order to understand the various financial implications that climate change may have on their real estate portfolios.