Commercial real estate investors, developers and analysts are putting climate forecasting on the map.

When commercial real estate companies started looking at sustainability more than a decade ago, they focused on disclosing and repointing, which helped raise awareness and understanding within the industry. Later, the industry moved to setting standards on how to report and implement sustainability measures. A similar path likely follows when addressing climate risks—including the apartment industry—although these risks and their impact on real estate values are expected to be more challenging to quantify.

When global real estate investment management firm Heitman began seeking greater climate risk transparency to improve its investment decisions and manage asset- and portfolio-level risk, it found that currently available data were not granular enough to assess the extent to which an asset is resilient in the face of today’s climate change realities.

Currently, climate-risk assessment typically relies on insurance models and public data sets, where historical occurrences are the basis for modeling the risk of natural disasters, though data availability, accuracy and transparency vary globally, according to its recent joint report published with Urban Land Institute in February “Climate Risk and Real Estate Investment Decision-Making Report.”

Because many insurance premiums renew annually, insurance companies take a short view and price risk only one year out based on probable weather and environmental risks. Institutional investors in property must consider longer-term risk that spans lengthier holding periods.

Heitman turned to scientific climate models that project long-term, global climate change impact and help clarify changing exposure for both acute, extreme weather events and chronic, industry-disrupting fluctuations, such as rising sea levels. However, scientific models can be challenging to access and apply to a large portfolio of real assets.

To help address these challenges, Heitman sought expertise from an emerging industry that combines next-generation climate maps with real estate data, thereby providing them with the best tools to begin effectively assessing and preparing for climate risk.

From the available partners in this emerging industry, Heitman selected Four Twenty Seven, a provider of market intelligence on the economic risk of climate change, to screen assets and potential new acquisitions and map climate risks around the world.

These new climate risk mapping tools enable Heitman to screen its current portfolio and potential new acquisitions usinghistorical weather and environmental risk data, as well as forward-looking climate models, to build an overall view of climate-related risks for Heitman’s properties, encompassing both acute and chronic risks.

For example, floods are mapped in 30-meter by 30-meter (98 foot by 98 foot) zones. “A property on one side of the street could have a higher risk score for flooding than the other, reflecting differences in elevation or proximity to a local body of water,” says Laura Craft, Head of Global Sustainability, Heitman.

Each asset is assigned a score from zero to 100 based on multiple dimensions—including risk related to cyclones, floods, earthquakes, sea-level rise, heat stress and water stress—and then benchmarked to these dimensions using a proprietary database of more than 1 million properties (See “The Point System”).

Heitman can now use these climate risk mapping tools to gain a better perspective of the risk profile and exposure of each asset and portfolio than what is provided through readily available data. Armed with this data, real estate investors can pinpoint areas most vulnerable to risk and, through further due diligence, determine if risk factors have been mitigated at the property and municipal level.

Climate’s Role in Investment Decisions

The climate risk assessment contributes to a holistic approach in constructing global property portfolios. Today, Heitman has screened its assets under management and is able to make better-informed decisions about asset weighting in specific portfolios. If a portfolio is determined to have a higher-than-targeted exposure, the portfolio can be rebalanced over time through limiting new acquisitions or exiting existing assets, exposed to a certain risk.

Jack Davis, Director of Program Development at RE Tech Advisors, last year led a webinar for Urban Land Institute (ULI) that covered climate risk assessment. Heitman’s Craft and Forest City Realty Trust’s Director of Sustainability and Corporate Responsibility Jill Ziegler were among the panelists.

“With climate risk, most folks are still figuring out what to do…. but know they need to do something,” Davis says. “What we’re seeing with our clients is two early approaches – first conducting some sort of climate risk analysis or assessment to identify properties that may be at increased risk. Second, we see many folks starting to adopt policies and due diligence practices to address these emerging risks.”

The aforementioned report, “Climate Risk and Real Estate Investment Decision-Making,” points to the pressing need for greater understanding throughout the industry of the investment risks posed by the impact of climate change. It also highlights proactive measures by Heitman and other leading firms to stay at the forefront of mitigation strategies and accurately price risk into investment decisions.

“Understanding and mitigating climate risk is a complex and evolving challenge for real estate investors,” ULI Global CEO W. Edward Walter says in published reports. “Risks such as sea-level rise and heat stress will increasingly highlight the vulnerability not only of individual assets and locations, but of entire metropolitan areas. Factoring in climate risk is becoming the new normal for our industry.”

Heitman Chief Executive Officer Maury Tognarelli says opportunities are emerging across the real estate industry for investment managers and investors to better assess climate risk and navigate the potential impacts of climate change on assets and portfolios.

“[Greater detailed information] and forward-looking data on the risks associated with climate change are becoming available, positioning the industry to incorporate climate risks into how investments are underwritten, and portfolios constructed,” Tognarelli says in published reports.

“Recently there has been greater focus by apartment investors and developers integrating climate risk metrics when making investment decisions.” Amy Groff, Senior Vice President of Industry Operations, NAA, says. “It’s still wise to consider diversity in portfolios, returns, opportunities, etc. Climate-risk analysis has become a part of this calculation—as there are better tools to assess the data and risks.”

A Reduction in Asset Liquidity

The real estate industry has just begun the development of more advanced strategies to recognize, understand and manage risks, and for the most part, presently relies on insurance to cover most shorter-term, financial-oriented risks related to climate change, the report states.

However, while insurance has remained generally attainable in risk-prone areas, being insured does not protect investors from a reduction in asset liquidity, according to Heitman. That, along with the likelihood of future changes in insurance availability and costs, is prompting a growing number of investors and investment managers to explore new ways to build climate risks into their investment processes, including:

• Mapping physical risk for current portfolios and potential acquisitions;
• Incorporating climate risk into due diligence and other investment decision-making processes;
• Incorporating additional physical adaptation and mitigation measures for assets at risk;
• Exploring a variety of strategies to mitigate risk, including portfolio diversification and investing directly in the mitigation measures for specific assets; and
• Engaging with policymakers on local resilience strategies.

Whether or not their assets have already been directly affected by the impacts of climate change, “investors see climate considerations as a necessary layer of fiduciary responsibility to their stakeholders, as well as an opportunity to identify markets and assets that will benefit from a changing climate,” the report notes. While early adapters have committed resources to gain knowledge and improve awareness of climate risk, in the coming years, methods are likely to become more sophisticated, it adds.

“The industry needs to be able to better measure the value affect so it can base its future decision-making on a quantitative rather than qualitative understanding of the risks and the potential return on investment from investing in mitigation strategies for their assets,” according to the report.

While awareness of climate risk is growing, none of the re port’s interviewees have yet ruled out attractive investment markets solely because of that risk, the report says. Still, interviewees emphasized the need to invest in a “sensible and smart” way in markets where physical risks from climate change are evident.

“Climate Risk” shows that leading investment managers and institutional investors are at various points in the undertaking of resilience scans of their portfolios. These scans help to identify vulnerabilities and impacts resulting from sea-level rise, flooding, heavy rainfall, water stress, extreme heat, wildfires and hurricanes. This includes short-term considerations such as business disruption for building tenants as well as higher operating and capital costs caused by increased wear and tear on properties.

Heitman uses emerging technology that combines next-generation climate maps with real estate data to manage climate risk. Providers of this technology use scientific climate models that project long-term, global climate change impacts and clarify the degree of exposure to both extreme weather events and chronic industry-disrupting fluctuations, such as rising seas. The real estate industry needs to understand the pricing impacts of physical climate risks, and how climate change is likely to have a bigger impact on valuation in the future as asset and market liquidity are affected, the report says. It identifies several steps to raise awareness, such as:

• Improve analyses of climate risk in annual and quarterly reports. This helps create awareness among investment managers and investors and helps drive change.
• Use big data to better understand patterns around changes in asset liquidity and value, and weather forecasting.
• Work with the insurance industry to understand data and gain knowledge on how climate change is affecting premiums and coverage.
• Engage with city leaders in vulnerable areas to support city-level commitment to and implementation of physical and transitional risk mitigation strategies.
   

“An eventual downward repricing of higher-risk assets will be the market’s way of redirecting capital to locations and individual assets where it is expected to be better insulated from these particular risks. This process will be painful for investors who are caught off guard, but those who are prepared have the potential to outperform,” the report concludes.

Editor’s note: Significant portions of this article are based on reports from Urban Land Institute (uli.org), Heitman (heitman.com) and Four Twenty Seven (427mt.com).