What is the impact of climate risk in real estate valuation?

by Gerhard Mulder of Climate Risk Services

Climate risk going to upend the traditional approach to valuing real estate. Yet, for many real estate investors, climate change is not yet front-of-mind, particularly those with shorter holding periods. The prevailing thought is that climate risk is a future problem and that an investor will be able to react before the risk materializes.

This is misleading in two ways:

  • First, climate risk exposure is current and near-term, as well as long-term.
  • Secondly, potential buyers or investors may already be factoring climate risk into decision making. A tipping point in investor sentiment may come sooner rather than later, at which point the music stops and someone will be left with a stranded asset.

What is climate risk?

Climate is the long-term average of the weather in a given place. While the weather can change in minutes or hours, a change in climate is something that develops over longer periods of decades to centuries. A changing climate introduces physical effects such as increasing frequency and/or severity of acute hazards such as heat waves, extreme precipitation, and forest fires; and chronic hazards such as drought and rising sea levels are expected to intensify. A changing climate also prompts action to mitigate or slow the impact that humans have on the changing climate, resulting in economic or socio-economic changes.

The Task Force on Climate-related Financial Disclosures (TCFD), which is part of the G20, divides climate-related risks into two major categories:

  1. Transition Risk: transitioning to a lower-carbon economy may entail extensive policy, legal, technology, and market changes. Transition risks pose varying levels of financial, regulatory, and reputational risk to organizations.
  2. Physical Risk: these can be event-driven (acute) or longer-term shifts (chronic) in climate patterns. Physical risks may have financial implications for organizations, such as direct damage to assets and indirect impacts from supply chain disruption.

Impact on Real Estate

The real estate sector is exposed to both physical and transition climate risk. Transition risk may hold the greatest near-term implications for the sector, through carbon risk and regulatory risk. Commercial real estate is a major emitter of greenhouse gas and other climate pollutants.

Governments around the world are showing real commitment to the 2015 Paris Agreement, which promises “to keep the increase in global average temperature to well below 2 °C above pre-industrial levels; and to pursue efforts to limit the increase to 1.5 °C”.

Regulators are also applying increasing pressure, demanding more transparency on climate risk from financial institutions. This deepening of the commitment to tackle climate change will cause fundamental changes to the real estate sector.

The overall consensus is that climate risk is not yet priced into asset valuations. This applies across sectors, including bonds, equities and real estate.

Climate risk can affect cap rates in two opposing ways. A purchase (or build) decision is based on the initial yield, which is unlikely to include climate risk considerations. However, investor sentiment may change within the holding period of the asset at which point the ‘going-out’ cap rate may start to reflect higher risk and thus a higher cap rate. However, climate risks may start to impact the cashflow even in the near term, for example through an increase in property taxes, insurance premiums and operating expenses. This will put downward pressure on net operating income, suggesting – all else being equal – a lower cap rate.

If a future buyer starts pricing this risk within the holding period of the current owner, there is a risk of a mismatch, this could lead to financial risk for the current asset owner.

Asset level vs Market Level Risk

We observe that there is a gap in the understanding of how climate risk fundamentally impacts the long-term value of real estate assets. While different elements of potential climate risk of real estate are being considered by some, there has not yet been a concerted effort to tie these elements into a coherent and comprehensive framework.

To properly understand the impact of climate risk on real estate we must understand what the long-term value drivers are. The traditional input to the real estate valuation formula includes:

  • operational costs
  • capital costs
  • rent growth
  • insurability
  • real estate taxes
  • terminal value
  • debt availability

Each of these components will be impacted by climate change. Many relate to the market in which the asset is located rather than the asset itself. Broadly spoken, the resilience of a market to the impacts of climate change is of critical importance to the future value of real estate located in that area.

This is different from most climate risk assessments for real estate that we see today. These generally focus on the asset-level risk and therefore only describe part of the problem.

Some examples of risk channels through which climate change will impact real estate value on the market level include:

  • debt availability (banks will require higher equity portion in the future, or start differentiating loan pricing based on whether the asset is located in a high risk area)
  • real estate taxes (some markets may have to invest heavily in climate adaptation measures, paid for by property taxes)
  • terminal value (the land portion of terminal value may decline if located in a high-risk area)

Conclusions and recommendations

Property professionals need to increase their awareness and build their capacity to understand climate risk and its dynamics. Climate risk should be incorporated throughout the organisation, including in the governance, strategy, risk management, identifying key metrics and setting targets.

The biggest mistake would be to treat climate risk as a compliance issue. This invites a tick-the-box approach, which ultimately may lead to significant loss of value. We don’t know when the music will stop, but once it stops the USD 11 trillion of real estate assets held by investors could readjust very quickly.

Be prepared by signing up for our course –

Climate Risk and Commercial Property Valuation

offered in collaboration by Cambridge Finance and Climate Risk Services.