Laurence Fink, CEO of the major investment management corporation BlackRock, had it right when he proclaimed in an open letter to other executives in 2020 that “climate risk is investment risk.” There’s little doubt that climate change has led to an increase in the frequency and severity of extreme weather events.
In the past six months alone, the country has seen historic flash flooding in the Greater New York City metro area and a “bomb cyclone” that hit parts of Northern California, some of which had been scorched by wildfires only a few months before. Meanwhile, the cleanup continues in Louisiana following the destruction left by Hurricane Ida. Climate change is getting more attention in the commercial real estate and mortgage industries, where environmental issues are beginning to drive a profound reassessment of how risks and values are analyzed in relation to assets.
If sea levels continue to rise and storms become more frequent as predicted, many communities will need to adapt or face the abandonment of certain properties.
Assessing the dangers
A major component of these changes is the use of the environmental, social and governance (ESG) concept as a framework for socially responsible investing. This movement calls for investors to consider environmental issues, social issues and the governance of a company — i.e., how executives attend to the interests of company stakeholders. The result is that commercial mortgage originators, brokers, investors and corporations that hold or trade assets are beginning to consider climate change in their allocations, investment strategies, risk analyses and site selections.
When discussing climate change, there are two main categories of climate-related risks that should be considered: physical risk and transitional risk. Physical risk can be defined as the likelihood of tangible property damage caused by climate change. It can be either acute or chronic. Acute risks are caused by extreme weather events such as fires, floods and hurricanes. Chronic risks are the result of long-term, global climate patterns such as extreme heat, drought or flooding from rising sea levels.
Transitional risks (or regulatory risks) involve disruptions to an asset or sector due to new or changing government policies, changes to technology or changes to markets in response to climate change. An example is the Biden administration’s executive order issued this past May that calls for building a climate-resilient economy.
For commercial mortgage brokers and their investor clients, physical property damage resulting from severe weather is a significant threat. For many years, the dangers of flood and fire damage have been offset by insurance programs and federal assistance that support post-disaster rebuilding efforts. These programs and others are being evaluated and rewritten under a new lens — and the commercial real estate finance industry must prepare for transitional risks on the horizon.
Rising property costs
When it comes to physical risk, the economic burdens are significant for properties that are subjected to climate change. These threats are expected to increase insurance premiums, operational costs for real estate, capital expenditures for mitigation measures and property taxes for protective infrastructure.
If sea levels continue to rise and storms become more frequent as predicted, many communities will need to adapt or face the abandonment of certain properties. Investors could be stuck with assets that have little or no value. Those that hold assets — such as real estate investment trusts, life insurance companies, and private and institutional investors — will need to consider climate-risk factors as part of their strategies.
With a movement to a low-carbon economy, investors can expect significant transitional risks. Many real estate professionals have already signed onto efforts such as the Net Zero Asset Managers Initiative, which supports the lowering of greenhouse gas emissions. Groups such as this are already incorporating efforts to lower emissions into their investment strategies.
Push for change
Transitional risk is anything associated with a change in government or corporate policy. Along with a focus on climate issues, other elements of the ESG movement are requiring the public and private sectors to review policies, procedures and strategies through the lens of ESG. Those that don’t face reputational risk in addition to any transitional risk.
In May 2021, the Biden administration issued executive order 14030, known as “A Roadmap to Build a Climate-Resilient Economy.” It charts a governmentwide strategy to prepare for climate risk and involves big changes to infrastructure, supply chains, energy and financial markets. Some of the most impactful elements of the executive order and related proposals involve major policy changes within various government departments.
More than 20 federal agencies have released adaptation and resilience plans to help safeguard federal investments from climate change. This includes proposed updates to the National Flood Insurance Program standards to help communities reduce flood risk through construction and land-use practices.
Each of these initiatives represents significant transitional risk. Many have overlapping implications, and anyone lending on commercial assets, or investors holding these assets, will need to be agile and swift to minimize transitional risks.
New investment rules
Among the agencies that are making policy changes is the Securities and Exchange Commission, which has started the process of implementing rules to require private issuers to evaluate and disclose the risks of climate change for their assets. This is expected to drive change within the secondary market for commercial mortgage-backed securities and rating agencies.
The U.S. Department of the Treasury has an initiative to address climate-related risks in the investment sector. This effort will focus on assessing the availability and affordability of insurance coverage in traditionally underserved communities and high-risk areas.
Proposed amendments to the Employee Retirement Income Security Act of 1974 are aimed at safeguarding savings and pension accounts from climate risk. The proposal calls for more recognition of climate change and other ESG factors by fiduciaries. These changes could ultimately affect the way that these entities allocate and invest funds, as many hold commercial real estate assets as part of their investment strategies.
The U.S. Department of Housing and Urban Development (HUD) is incorporating climate considerations into the origination and underwriting of mortgages for single-family homes to better address these risks within HUD loan portfolios. The Department of Veterans Affairs and the Department of Agriculture are similarly reevaluating their loan programs.
Measuring the impact
Advancements in data aggregation, analytical modeling and artificial intelligence are making it easier to understand the long-term impacts of climate on commercial real estate. The industry has lacked a national standard for measuring climate-related risks, but that may be about to change. This past May, ASTM International (which develops standards for a wide range of products, systems and services) formed a climate change subcommittee that is tasked with developing a framework for the creation of industry standards.
Other ESG-driven standards have been developed recently. In 2019, ASTM issued guidelines for measuring a building’s energy consumption in an effort to drive efficiency and reduce greenhouse gas emissions. While this standard is only starting to be applied, it is an example of the increased focus on climate-driven initiatives.
The private sector has partnered with technology companies to address issues and bring new modeling tools to market. An example is the company ClimateCheck, which works with property buyers, owners and brokers around the country to deliver climate-risk rating reports for specific properties or entire portfolios. The rating system addresses climate-related hazards (such as floods, fires, droughts, storms and warmer temperatures) and projects how they will change over time.
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Building climate resilience into commercial real estate investment strategies and lending practices can help avoid or limit exposure to both physical and transitional risks. While it is difficult to completely separate a commercial real estate portfolio from climate risk, mortgage brokers should know that investors and lenders are beginning to look at available data and reports in an attempt to understand and limit their exposure to vulnerable markets. They also are implementing mitigation options for their investments and watching legislative matters more closely. ●