Climate change knocking, but not all managers home

Some of the most in demand regions in the U.S. for real estate investment, most notably the Sun Belt, are also getting clobbered by the floods, extreme heat and other ravages of climate change — potentially impacting returns.

It's a worldwide challenge that is threatening to chisel away at expected returns across real asset sectors, from housing and office to retail. Some real estate managers are starting to exit properties early or decline to invest in real estate with relative good near-term return potential but at substantial climate risk.

There were 20 extreme climate disaster events with losses exceeding $1 billion in the U.S. in 2021, including one drought, two floods, four tropical cyclones and 11 severe storms, according to the National Oceanic and Atmospheric Administration, much of it in the Sun Belt, an area in the U.S. that stretches from the Southeast to the Southwest.

Between 1980 and 2021, the annual average was 7.7 events, increasing to 17.8 events on average in the most recent five-year period, 2017 to 2021. NOAA defines extreme weather as an event that costs $1 billion or more, adjusted for inflation.

The three states most vulnerable to extreme weather are all in the Sun Belt: Texas, Louisiana and Florida, NOAA said.

There’s been “an unmistakable move” of people to the Sun Belt, which increased demand for real estate in the region, especially apartments, said Jacques Gordon, Chicago-based global head of research and strategy at LaSalle Investment Management. At the same time, the Sun Belt is among the regions that are most at risk due to climate change.

Australia, the southern U.S. and the U.S.’s Eastern Seaboard had the “most acute rises in sea levels” in the developed world from 1993 to 2020, according to a new LaSalle paper on the demographics of migration.

Climate change, climate migration and its resulting impact on the value and demand for properties isn’t a theoretical issue for real estate money managers. Climate change can make owning real estate more expensive due to increased cost of insurance, mitigation strategies and possibility of stranded assets unable to attract further investment. And real estate managers’ inattention could make it more difficult for them to exit the investment before climate change takes a bite out of returns, Mr. Gordon said.

Long-term investors like LaSalle have to pay attention to the impact of climate change, he said. If property owners can no longer insure buildings, if cooling buildings gets too expensive, in a decade or less, those properties could become stranded assets, Mr. Gordon said.

Managers that are proactive are investing in properties located in areas with infrastructure in place to help protect properties from rising sea levels, extreme heat and volatile weather, the LaSalle report said. For example, some managers are installing heating and cooling units on rooftops, rather than basements prone to flooding, the report said.

Those risks, however, haven’t dissuaded people and investors from migrating to areas that are most at risk from climate change, Urban Land Institute’s Emerging Trends in Real Estate 2022 report shows. The top eight metropolitan areas for real estate investment are in the Sun Belt, replacing coastal urban areas such as San Francisco and Manhattan, the report said.

“Investors have been slow to incorporate environmental risks into underwriting,” the ULI report said.

According to ULI’s survey, real estate industry executives are slightly more concerned about climate change generally than they are about the “risks from extreme weather” — both ranked of moderate importance on a 1 to 5 scale, with overall climate change ranked 3.43 and extreme weather risk ranked 3.13.

“That may change if affected areas are subject to increasingly frequent events, and insurance rates rise,” the report said.

With heavier investor demand in the Sun Belt, which is already experiencing floods, extreme storms and hurricanes due to climate change, “greenhouse gas emissions … from the operation and maintenance of real estate” will increase, said Zach Swartz, Richmond, Va.-based counsel in the capital markets and mergers and acquisitions practice of law firm Vinson & Elkins LLP. He represents real estate managers and other real estate investors.

Real estate investors are still “bullish on the Sun Belt,” driven by a big influx of people moving there for a better quality of life, lower cost of living and lower taxes, especially in Florida and Texas, Mr. Swartz said.

So far, they have been rewarded, he said. The most pronounced increases in real estate prices have been in the Sun Belt due to the increased demand.

Even so, real estate managers are beginning to recognize that real estate is a big consumer of energy and a significant contributor to greenhouse gas emissions, both from the maintenance and the construction of projects, he said. Concrete and steel are “highly carbon intensive,” Mr. Swartz said. Even so, “we are building more buildings, not cutting back on that,” he said.

However, recent studies are showing that more sustainable, less carbon-intensive properties offer better returns, Mr. Swartz said.

A 2020 Massachusetts Institute of Technology study revealed that properties with healthy building certifications, for example, reaped higher rents of 4% to 7% per square foot over uncertified buildings.

A healthy building promotes the physical, psychological and social health of its occupants with components including good ventilation and air quality, a comfortable temperature, low noise levels, and natural light, according to the Harvard T.H. Chan School of Public Health.

Eighty-seven percent of the surveyed real estate executives reported increased demand for healthy buildings over the past 12 to 24 months, and 92% expect demand to grow over the next three years, according to a recent report by the United Nations Environment Programme Finance Initiative.

Green buildings also garner higher rents and capital values, while costing less in monthly operating and maintenance costs, a November report by real estate money and asset manager CBRE Group Inc. said.

Rent for U.S. offices that are LEED-certified are 5.6% higher than those for non-certified office buildings, CBRE’s analysis shows. LEED is a rating system by the U.S. Green Building Council.

Currently, rental premiums on green buildings are “only discernible in the office sector,” CBRE noted. Green buildings also tend to be newer, making the premium analysis more difficult, CBRE said in the report.

Real estate managers are starting to take notice of the mounting evidence of a “green premium,” with environmentally friendly processes starting to be built into due diligence and the financial contract terms, Mr. Swartz said.

Some larger real estate investment trusts that have corporate level debt are starting to issue “green bonds,” which have provisions that if the company achieves a green certification, such as the Fitwel healthy building certification, and cuts emissions by a certain percent, they would pay a lower interest rate on the debt, Mr. Swartz said.

Higher sales prices, rent premiums and lower cost of capital for green buildings “naturally translate to better returns,” Mr. Swartz said.

But U.S. real estate investors are substantially behind Europe and somewhat behind Australia in ensuring buildings emit less carbon and are more environmentally friendly, despite what seems to be a “direct link” to higher rents and lower costs of energy-efficient properties, said Stephen Hayes, Sydney-based head of global property securities for First Sentier Investors, a global money manager with about $174 billion in assets under management.

Some managers, especially in the U.K. and continental Europe, are working to reduce the energy intensity of buildings. New buildings are being built with the sun’s heat in mind, using green building materials and adopting smart energy metering, Mr. Hayes said.

Ultra modern buildings emit 55% less carbon than older real estate stock, Mr. Hayes said.

Some cities in Europe such as Amsterdam are also bulking up defenses against rising seas and other impacts of climate change, the LaSalle report noted. Cities and regions that take measures to be sustainable in the face of the impact of climate change will be more in demand and increase in value over areas that do not, the report said.

However, Mr. Hayes said it is most important to reduce carbon and take other measures, thereby getting to the cause of climate change.

“We are encouraging the real estate industry to have a greater focus not only measuring operational carbon” but setting targets to reduce their carbon footprints, offsetting the risks through such actions as installing on-site renewable energy sources, he said.

And property owners in the U.K. and the rest of Europe are starting to retrofit older buildings to make them more environmentally friendly, a trend that is in its earliest stages, Mr. Hayes said.

“Landlords in the U.K. and Europe are starting to measure carbon,” he said. “The great majority of the real estate sector, particularly in the U.S., is ignoring” their carbon emissions.