For smart investors, making decisions about the value and return on investment (ROI) of a given opportunity – whether stocks, bonds, a business venture, or an investment property – is all about measuring potential risk against potential reward. What happens, then, when the risk changes with potentially catastrophic results? That is the question being asked by real estate firms as they attempt to assess the increasing climate risk on real estate investments.
Calculating Climate Risk and Real Estate Investments
According to a new report released this Spring by the Urban Land Institute (ULI), many of the markets favored by real estate investors are among those most endangered by the increasing risks associated with climate change, “ranging from more intense and frequent weather events such as hurricanes, typhoons, and wildfires, to more gradual changes such as sea-level rise or shifting weather patterns.”
These risks are not just associated with individual properties and portfolios. According to a 2018 report published by climate analytics firm Four Twenty Seven and real estate technology company GeoPhy, those wishing to mitigate risk by investing in real estate investment trusts (REITs) also have significant exposure to climate-related losses, with 35% of REIT properties sharing “geographic exposure to climate hazards including inland flooding, typhoons or hurricanes, and coastal flooding, and elevated sea levels.”
In addition, the insurance industry has been particularly affected by shifting risk assessments, resulting in heavy losses and driving a move toward refusing coverage of homeowners insurance in california and other at-risk markets. Because one of the big selling points of REIT has always been the insurability of the investment against loss, an interruption in the ability to obtain coverage is potentially disruptive for the industry.
ESG Strategies to Mitigate Climate Risk in Real Estate Investments
For those who are still interested in investing in REITs, the sector is incorporating investment strategies focused on climate risk, taking into account environmental, social, and governance (ESG) factors and their impacts on markets and market potential.
Strategies associated with ESG criteria focus on sustainability in investment properties and development projects, including green building techniques, social and community relations and philanthropy to create shifts in markets, and the impact of governance with a focus on the impact of growth, climate, pollution, and toxicity on the environment.
Investment products to come out of the push for ESG investment criteria include both index funds and a mutual fund focused on REITs and committed to sustainability and enlightened governance. As climate risk becomes a more mainstream measure of viability, the opportunity to invest in REITs with a focus on ESG criteria should become more prevalent.
Best Practices for Measuring and Managing Climate Risk
According to the ULI report, proper risk assessment involves both measuring and managing risk. Here are the best practices they’ve identified for both.
Mapping Physical Risks
Understanding the effects of geographic features, environmental trends, and population distribution on potential risk is a key component of properly understanding the financial stakes of climate change. Sea-level rise, flooding potential, increasing temperatures, all of these should be assessed and tracked to determine changes over time.
In addition, infrastructure, business disruption, emergency response, and other factors should be taken into account in order to determine how adaptable and responsive the local market will be in the event of a climate-related emergency.
Due Diligence and Decision-Making
While due diligence has always been part of good investment decision-making, investors will need to come to their due diligence process with more than an eye to past performance or market conditions. A clear-eyed assessment of not only current conditions but trends and forecasting in order to properly assess the climate risk on real estate investments is necessary to ensure that investment potential is evaluated for both short-term and long-term solvency.
Mitigation for Current At-Risk Assets
Many investors will no doubt find that they have current investments that require adjustments in management, operations, and insurance coverage levels in order to ensure they are properly protected. While additional capital outlay to make properties more resilient in the face of extreme storms and hotter summers will cut into short-term profitability, it can ultimately protect the investment over the long term, preserving value and viability.
For some investors, of course, portfolio adjustments may be called for. If an assessment of current risks and future projections results in a reasonable belief that profitability is not sufficient to justify increased expenditures, a sell-off of some properties may be necessary. This could provide significant upside for investors willing to make capital investments in these properties, as the cost of acquisition could be significantly reduced.
Worried About Climate Risk and Real Estate Investments?
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