1. Running the numbers on LEED-certified multifamily and office buildings
Due to increased energy load on urban assets and city power grids, owners of urban assets will likely see cost increases in the short-term, which will place additional pressure on rents to cover those rising costs. Owners seeking space to fill their needs may therefore look to other markets where detrimental trends are not as prevalent and the costs to run those assets are not as high. This could translate to a shifting portfolio environment for asset managers.
While some tenants may leave to save on energy costs, the majority that stay put will look for the most energy-efficient and cost-effective locations. Clients who seek updated assets that hold LEED certifications or similar certifications may not necessarily avoid the higher improvement costs in the near-term, but data indicates they are likely able to reap the long-term returns on a revenue per available square foot basis (RevPAF). RevPAF combines the effects of occupancy and rents into a single variable, and recent studies have found that higher rents more than make up for the marginally lower occupancy that LEED-certified assets experience. Cushman & Wakefield recently conducted an analysis in March 2022 for Gateway-Plus markets (defined as New York City, Los Angeles, Chicago, San Francisco, San Jose and Washington, DC) aimed to discover any measurable premium for rents and revenue for LEED-certified multifamily assets. The analysis controlled for asset class (Class-A only) and quality while selecting CBD and urban submarkets consisting of 50 or more units, with a focus on rental and sales rates.
The following graphs depict LEED-certified versus Non-certified Effective Rent Premiums and LEED-certified versus Non-certified RevPaF for multifamily properties from fourth quarter 2020 through fourth quarter 2021:
U.S. CRE's Environmental Performance - LEED vs Non-certified Rent Premium
U.S. CRE's Environmental Performance - LEED vs Non-certified RevPAF
2. Defining direct and indirect effects of climate change on assets
For the purposes of this discussion, we define direct effects from climate change on U.S. commercial real estate assets as effects immediately stemming from overall global warming. Examples of this include the increased number of severe climate events per year (i.e., an increased intensity of wildfires measured by an increased number of acres burned per event, increased number of hot days per year, or increased severity of hurricane events). This can be compared to indirect effects from climate change on U.S. commercial real estate assets, which we define as effects that result from the incidences that global warming causes. Examples of these include changes in human population migration patterns such as outmigration flows, increased demand on finite water sources, and reduction in air quality over time. As further discussed in the next section, both can have a profound influence on properties.
3. Identifying possible future effects of climate change on assets
While nationwide consensus has largely been reached regarding today’s rise in global temperatures and the direct link to human activity, future effects from that warming are still being discussed. This is especially true with the consequences that result from negative climate externalities, like changes in migration patterns, and more specifically, outmigration flows due to disaster displacement.
Disaster displacement may happen less frequently than more direct effects like the growing number of hot days per year in certain metro areas, but this does not mean that their effects are any less detrimental. Referencing examples like Hurricane Katrina in 2005, the U.S. commercial real estate market could see a decrease in leasing velocity, an abrupt rise in vacancy and erosion of the talent pool in future disaster-affected areas. These represent a major long-term issue to commercial market fundamentals if the frequency of outmigration increases and could ultimately lead to national property portfolios being rebalanced or redrawn as a result.
Not only do negative climate externalities like outmigration flows due to flooding add significant strain on commercial real estate fundamentals, but on their assets and operations as well, causing a negative collateral impact to a company’s image if they stall or stop for an extended period. While the accuracy of weather forecast models has improved greatly, allowing companies to proactively respond to extreme weather, it is inevitable that a weather event could be more damaging than expected. According to researchers from the University of Colorado, the incidence and intensity of these events is forecast to increase, meaning owners and occupiers of industrial properties will need to be proactive in implementing strategies that can help mitigate the risk (Bernstein, Asaf et al, 2018).
Cities and Climate Change
In some cities where these adverse effects have occurred, steps have been taken to ensure that future risk of infrastructure damage is mitigated and that the above effects are minimized. After Hurricane Katrina devastated Louisiana in August 2005 and caused roughly $161 billion in damages, $15 billion in funding was approved for various mitigation projects.
In September 2018, the city of Houston adopted a floodplain ordinance in response to Hurricane Harvey, which resulted in an estimated $125 billion in damages. The ordinance, known as Chapter 19 Code of Ordinance, requires new developments to be built 24 inches above the 500-year floodplain instead of 12 inches above the 100-year floodplain, and increases the mitigation fill requirements.
Similarly, New York City has taken expansive measures to ensure devastation from events such as Hurricane Sandy in 2012 are properly addressed. The event caused approximately $70 billion in damages and has led to major steps to protect much of the city’s most valuable real estate, such as the Lower Manhattan Costal Resiliency (LMCR) project, and the Battery Park City Resiliency (BPCR) project. Representing billions of dollars in climate change mitigation efforts, the plans include floodwalls along the waterfront buried into the landscape, overhauls of stormwater infrastructure, and infrastructure improvements to piers, docks, water transportation terminals, and waterfront pedestrian access points.
The SEC and Climate Change
Cities aren’t the only entities taking steps to ensure climate change is addressed for future years. The U.S. Securities and Exchange Commission (SEC) proposed a rule in late March 2022 that would require public companies to provide detailed disclosures about the level of climate-related risk they are exposed to; their climate-related risk management process; how their business model, financial performance, and future earnings outlook are likely to be affected; as well as the bottom-line financial impact of climate-related events they have experienced. Furthermore, the pending rule would require all public registrants to disclose their direct greenhouse gas (GHG) emissions, any indirect GHGs, and any additional GHGs resulting from its value chain activities.
4. Assessing insurance costs relative to regional climate risk
Location-specific environmental risk mapping through rankings allow investors to manage their portfolio of assets more efficiently where differing levels of risk are involved, and crucially, protect those assets with varying insurance policies based on that risk.
As the incidence and severity of catastrophic weather events rises, so too does the cost of insurance policies in areas most likely to be affected by those events. According to data collected from the National Oceanic and Atmospheric Administration (NOAA), costs of climate disasters in the four-year period of 2015 through 2018 totaled $500 billion, nearly double the $254 billion cost of the previous four-year period of 2011 through 2014. As the costs of property damages increase, the expectation is that insurance companies will pass the costs onto owners, which means owners need to be prepared to absorb any increases in insurance premiums passed down. Typically, costs of improvement have been mitigated through alternative capital sources, such as catastrophe bonds and recently, green bonds, which can serve to improve the green rating of owners’ portfolios while also allowing for potentially higher future cash flows.
After identifying that coverage costs for assets will be larger in higher-risk areas and outlining several methods to mitigate those costs over time, quantifying this risk for owners is the next step to keeping them and their portfolios protected. One way this can be achieved is to utilize risk analysis tools, such as a model portfolio analysis completed by Lockton Companies and National Real Estate Advisors, LLC. The analysis tool measured risks associated with disasters like inland flooding, tornadoes, and hurricanes (to include coastal storm surge), concluding that catastrophic risk from hurricanes is by far the greatest of these disasters, and that the metro area with the highest risk is Miami, with an average annual loss of $767,000.
The following table depicts a model portfolio that determines asset value and average annual loss based on risk exposure in various markets, as found by Lockton Companies and National Real Estate Advisors, LLC in 2017.
5. Recommendations for future-proofing a portfolio
While the effect of negative climate externalities on commercial real estate in the U.S. varies, market participants should continue to future-proof their portfolios.