Earlier this summer, the Intergovernmental Panel on Climate Change (IPCC) released its first report since 2013, Climate Change 2021: The Physical Science Basis. IPCC, the UN body for assessing the science related to climate change, warned that climate change is already affecting every region on Earth. Even worse, many of the changes already set in motion are irreversible.
Some aspects of climate change may be amplified in cities, according to IPCC. These include increased temperatures, flooding and sea level rise in coastal areas.
But the vast majority of multifamily investors are ignoring the alarm bells when it comes to their acquisition strategies. Byron Carlock, national partner and real estate practice leader with professional services firm PwC, says climate change has yet to emerge as a significant factor in investment decisions.
“There’s been a lot of talk about climate change, and we’ve been looking for it to show up in transaction activity, but it’s not,” Carlock notes. “Prices are still holding up, and thus far, climate change is still considered an insurable risk, though insurance rates have gone up dramatically.”
At what point will multifamily investors pay attention to climate disasters? And when will they rethink their investment strategies to avoid regions that are particularly vulnerable to climate change?
“It seems likely that an increased appreciation of climate risk will bring with it broad changes in the way capital is allocated and managed, but those changes will take time, particularly in an illiquid asset class like real estate,” says Bryan Reid, executive director of MSCI’s global real estate solutions research team.
No redlining, yet
Over the past few years, the frequency of extreme weather and climate-related disasters with losses exceeding $1 billion has skyrocketed. Of the 10 costliest natural disasters in 2020, six occurred within the U.S., according to Munich RE, a global provider of reinsurance, primary insurance and insurance-related risk solutions.
And there’s been no reprieve from climate-related disasters this year. For example, only two months into 2021, Texas suffered a deep freeze, with temperatures dropping below zero across much of the state. This summer has been marked by devastating wildfires and hurricanes.
Yet, the extreme weather and resulting losses seem to have had little or no impact on multifamily investors. In spite of the winter freeze, Dallas-Fort Worth led the way in apartment investment in the first half of 2021, with $7.7 billion in properties changing hands, according to real estate services firm CBRE. That represented 8.4 percent of total sales in the United States.
Likewise, multifamily investors are pouring money into Phoenix. The metro area ranked third for multifamily investment activity during the first half of the year, with $5.7 billion worth of transactions, according to CBRE. That volume was three times more than the same period last year and 36 percent higher than that recorded in the first half of 2019.
All this investment activity has occurred while more than 1,000 fires have burned across Arizona, fueled in part by a megadrought and unusually hot temperatures.
This level of investment interest and activity proves that multifamily investors and developers aren’t too concerned about the risk that climate change presents to their portfolios, even when they witness it. For example, investors are still flocking to Seattle, despite the brutal heatwaves the Pacific Northwest has experienced this year, and developers continue to build in coastal Florida despite the threat of more intense hurricanes and flooding.
“I see investors acknowledging the reality of climate change, and I would expect that there would be more redlining [of certain areas], but we’re not seeing that yet,” Carlock says.
Reid is quick to point out that investors will always be faced with some risks. Moreover, they also have differing investment goals, market expectations and risk appetites, so they likely won’t act in unison.
“Like climate change, changes in investment activity driven by increased climate awareness may not manifest overnight, but they are happening,” Reid says.
Assessing climate risk
Climate-related risks go beyond direct physical damage for commercial buildings. A 2019 report by BlackRock Investment Institute, Getting Physical: Scenario Analysis for Assessing Climate-Related Risks, pointed out that risks could include higher insurance premiums or decreased insurance coverage, rising operational costs such as energy use for air cooling systems and greater capex needs to make buildings more resilient.
Additionally, BlackRock’s report warned that climate change could result in increased delinquencies as tenants default or walk away from properties after extreme weather events. Finally, climate change could create potential hits to valuations and declining liquidity for properties in vulnerable areas.
With energy or utility costs making up around 15 percent of operating expenses for commercial buildings, and building maintenance and insurance costs averaging roughly 20 percent, BlackRock concluded that “investors who are not thinking about climate-related risks, or who view them as issues far off in the future, may need to recalibrate their expectations. Some physical changes—such as slowly rising sea levels—can seem outside of a traditional investment horizon. Yet the most pressing risks, such as exposure to hurricanes, wildfires and droughts, are clear and present—and often hidden in investors’ portfolios today.”
John Siegman, founder of HazardHub, a provider of comprehensive property risk data, hopes that multifamily investors will eventually include climate risk in their underwriting and proformas. But right now, they’re far more concerned about other things.
“On a scale of 1 to 10, I would say climate change ranks at about three or four for multifamily investors and developers,” Siegman says.
Part of the problem is that multifamily investors don’t take advantage of the data and technology tools that exist to help them assess the level of exposure their properties have to climate-related risks.
That’s one reason HazardHub is partnering with Cherre, a real estate data management and analytics platform that raised $50 million in growth funding earlier this year. The partnership allows customers to connect HazardHub’s 100 billion data points with Cherre’s core real estate datasets for strategic risk analysis, planning and underwriting.
Cherre CEO and Co-founder L.D. Salmanson says more extreme weather patterns are creating higher demand for environmental data and the ability to connect it with other core real estate data sets so investors can create a holistic view of the risk and potential return within their portfolios.
Likewise, CoreLogic has seen demand for its climate-focused analytic modeling data increase substantially, expanding from insurance companies to commercial real estate firms, according to Tom Larsen, principal of insurance solutions.
“As we’ve had pretty severe hurricane seasons and wildfires, we’re seeing concern and desire for education grow [within the commercial real estate industry],” Larsen says. “We’re getting more inquiries from CRE professionals now than we were five years ago. And while significant uncertainty remains in the forecasting of the effects of climate change, the science available now is sufficient to begin identifying and quantifying the future climate change risks to individual properties. This can help us manage the disruption from climate change.”
Preparing for the worst
Many experts doubt that climate risk will prevent developers from building new multifamily communities or investors from acquiring properties in higher risk locales. Instead, they will mitigate that risk with insurance and/or physical modifications such as fire-resistant building methods and hurricane resistant construction.
“So long as demand for real estate in risky geographies drives prices up to a level where investors can mitigate risks and still turn a profit, they will continue to develop,” says Jeff Wakefield, Ph.D, senior consultant and principal specializing in natural resource economics with Cardno, a global infrastructure, environmental and social development firm that offers built asset climate-resiliency assessments.
Real estate investors who acknowledge climate risk make investments decisions based on insurance availability and premiums, Wakefield says. If risks can be hedged at a cost that the market will bear, then most developers and investors will proceed.
With more advanced climate-related analytics and modeling, investors can anticipate extreme weather and insure their properties accordingly, according to Larsen. However, some risk may become difficult to insure at reasonable rates, which makes relying on insurance a shaky strategy in the long term.
Currently, the U.S is in a “hard market” for property and casualty insurance. A hard market occurs when insurance is expensive and in short supply.
Premiums are expected to surge 7.1 percent this year, up from 2.5 percent in 2020, according to a forecast by the Insurance Information Institute and Milliman. Premium growth is projected to slow in 2022 and 2023, but will likely remain above 5 percent during both years.
Some investors are choosing to spend money on practical risk mitigation strategies such as the adoption of more fire-resistant building methods and hurricane-resistant construction rather than more insurance.
By and large, they’re not adopting strategies that are so costly today that they could only be justified if adverse outcomes become much more frequent in the future. Instead, they’re making these decisions based on a cost-benefit analysis that relies on current perceptions of climate risk.
But it’s important to remember that the current risk exposure of any particular location does not necessarily correlate with future risk exposure, says MSCI’s Reis.
“Don’t be naive and assume that extreme weather patterns won’t impact you,” warns HazardHub’s Siegman. “We’re witnessing extreme weather events every year—your property will be impacted at some point. It’s not something that you can shy away from, but something that you have to plan for.”