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Incorporating physical climate risk into real estate valuations is no easy task. Olivia Muir, Head of Sustainability – Real Estate & Private Markets, offers some reflections on what to consider.
For decades, asset-level forecasting and modelling has indirectly considered ESG items. In particular, expected operating and capital expenditure have long been important components of an asset’s projected cashflows; they have clearly been implicitly influenced by a building and its location’s sustainability characteristics.
However, at a market or national level, forecasts historically have focused on economic inputs such as inflation, population growth or GDP growth. But with extreme weather becoming an increasing risk, including environmental inputs in market-level forecasting exercises is proving to be necessary.
So how can we estimate and include a market or country’s environmental outlook in forecasts in a consistent and quantitatively accurate way?
Tools that score locations according to their physical risk are swiftly becoming an important input into macroeconomic and real estate forecasts. There is also a timeframe consideration and challenge; economic forecasts are less accurate the further out they go and thus economic modelling tends to focus on the near term (1-5 years), while most environmental tools consider longer timeframes, usually to 2030 or 2050. Ignoring this environmental-economic link will likely lead to costly repercussions. How on this warming Earth could a real asset investor not consider physical risk when determining which markets to invest in? According to Munich Re, natural disasters caused losses of around USD 270 billion in 2022, with less than half of those losses actually insured.
Picture this: a long-term property investor is advised to allocate to Miami in 2020-21, a hot and growing market based on economic expectations by a trusted forecaster (who, as it happens, is not considering physical risk in their MSA modelling).
The investor buys in downtown Miami in 2021, suffers floods twice in four years and, unsurprisingly, incurs sharps hikes in insurance premiums over time. Refinancing comes around and lenders are wary given the building’s location and flooding history, with debt being secured from a thin pool of lenders. The next refinancing might not be successful.
Rising insurance costs, unforeseen capital expenditure related to repairing damage and preparing for future water invasions, along with physical-risk-conscious lenders cause this 8% IRR expected at acquisition asset to become loss-making within a few years.
An investment decision made based on economic forecasts for Miami to outperform other real estate markets, failed to consider the city’s physical risks. Other cities such as Tokyo, Mumbai, New York and London are also at severe risk of rising sea levels. Assets are exposed to physical risks that may affect their value; these must be considered in economic and market forecasts. So shouldn’t long-term investors in these (and other) markets, that will be exposed to physical risk, be factoring this in when considering future performance of that market or country? I certainly think so.