We are facing a risk crisis across the real estate landscape as tenants and investors look to shore up the environmental performance of assets and portfolios.  Climate risk is becoming a lynchpin in the conversation on insurance and asset valuation across key markets, none more so than in the US office market, and it’s a cautionary tale for Australia’s commercial sector.  “Considering decarbonisation is no longer optional.” That’s the advice from ULI co-executive director of the Randall Lewis Centre for Sustainability in Real Estate Marta Schantz, who says real estate players are now “paying attention and incorporating building emissions into [investment] decision-making”. “We are seeing more and more real estate firms incorporating ESG into their due diligence,” Schantz says.  “They’re identifying brown assets, buildings with higher climate risk, and are incorporating these considerations into their real estate transactions.” Climate risk not just a bricks and mortar issue Schantz explains that brown assets often face bigger demands for climate policy compliance to avoid the risk of becoming a stranded asset.  In a report on climate risk disclosures and the future of real estate investment by the ULI and Heitman, it outlines two types of climate risk that assets face. ▲ ULI co-executive director of the Randall Lewis Centre for Sustainability in Real Estate Marta Schantz. The first is physical risk, relating to damage from extreme storms, or longer term issues including threats from rising sea levels or prolonged drought.  The second is the transition risk.  This is described as “business risks associated with climate change and the transition to a low-carbon economy”.  Heitman global head of portfolio sustainability strategies Laura Craft says these risks are less apparent but equally important.  Craft says they can include policy changes, reduced resource availability, increased cost of insurance, higher taxes and the potential for reputational and market shifts.  ‘Insurance crisis is really a risk crisis’ Craft says insurance companies are moving out of some coastal markets in the US, which is proving problematic for smaller real estate investors.  “Larger investment real estate portfolios, which have a combination of coastal and heartland exposures are likely insured with a blanket policy … which allow insurance companies to collect premiums and spread risk across the country from coastal exposures,” Craft says. “In light of this, the pool of potential buyers of coastal properties may be limited to real estate companies (institutional investors). ▲ Heitman global head of portfolio sustainability strategies Laura Craft. “In our experience, real estate companies are working on different structures of insurance programs that will allow them to self-insure or prefund deductibles to manage the potential financial risk of high insurance costs.” ULI’s Marta Schantz says the so-called “insurance crisis” is actually a risk crisis.  “The spiking price and uncertain availability of insurance is a direct reflection of the level of risk,” Schantz says.  “For insurance to become a more reliable input, real estate needs to consistently assess and address their physical climate risk in tandem with meaningful reduction of greenhouse gas emissions.” Home insurance premiums are one of the leading causes of a spike in the increased cost of living, according to recent Australian Bureau of Statistics data.  Median home insurance premiums have leapt 28 per cent in the 12 months to March 2023, while high-risk properties, including those in flood-prone areas of Australia have endured a 50 per cent spike.  Two major home insurers, QBE and Suncorp, signalled they would likely raise their premiums an additional 10 per cent to keep in step with the rising tide of claims from natural disasters, higher inflation and reinsurance cost pressures.  The east coast floods of 2022 were one of the most expensive natural disasters for Australian insurance companies on record, with a repair bill of $1 billion.  Reinsurance costs have surged globally but Australian insurers are paying up to 30 per cent more for reinsurance, which is having a bottomline effect.  But asset owners taking a proactive approach on climate risk mitigation could be rewarded, according to Craft.  ▲ The east coast floods of 2022 were one of the most expensive natural disasters for Australian insurance companies on record. “Investors are paying closer attention to potential rising insurance costs and the expanding regulatory environment which could drag on the modelled investment returns over time,” she says. “From a brown discount perspective, investors are increasingly seeking to model the financial impacts of upgrading inefficient assets and the risks of climate into investment decision-making processes with a goal of producing highly efficient and well-run properties.” These climate-aware assets will lure greater investment and drive values to greater heights.  Risk disclosures should be standardised: RBA Proposed mandated climate data for real estate assets in the US could significantly move the needle on benchmarking building performance standards. The Securities and Exchange Commission is in the process of implementing the Climate Related Disclosure Standards for publicly traded companies, which is due to be implemented next year.  In Australia, NABERS and NAThers ratings are used to arbitrate a building’s environmental performance. But the US is lagging on this front.  The ULI-Heitman report says investors could rely on mandated climate data to inform their investment decisions based on emissions and physical climate risk.  “The information could help determine whether assets will suffer ‘brown discounts’... it might affect which companies or assets are included in ‘green’ investment funds,” the report said. “But mostly, it will push real estate industry participants to follow best practices for transparency regarding climate risks, to report on how they have or plan to adapt to climate impacts already apparent, and to report their progress on achieving operating targets regarding decarbonisation.” ▲ The term ‘green swan’ refers to events due to climate change, which will occur more and more often in the future. Craft says asset owners will need to be proactive in addressing climate within product offerings and at the asset level.  The Reserve Bank of Australia put out a paper this year referencing a ‘green swan’ event as an extreme example of the impact of climate risk to insurers of large asset portfolios.  “They are vulnerable to significant falls in value. The risks to this part of their operations are similar to those facing other asset managers such as superannuation funds, although Australian insurers typically have asset allocations skewed towards lower risk assets,” the report said.  “Physical climate risks can cause the value of property and infrastructure assets to fall, whether through direct damage or reduced productivity. Transition risks may affect the valuation of firms, especially in emissions-intensive sectors.  “A severe stress scenario could see the asset management sector amplify a negative shock through fire sales of assets, increasing systemic risk and leading to a ‘green swan’ event.” The central bank also puts forward a less extreme scenario illustrated in the Bank of England’s 2021 Climate Biennial Exploratory Scenario, which modelled insurers’ asset values falling between 8 and 15 per cent. It recommends that climate risk disclosures should be consistent and comparable between firms, industries and countries “to allow for the global nature of climate shocks and financial linkages”.  You are currently experiencing The Urban Developer Plus (TUD+), our premium membership for property professionals. Click here to learn more.
