For any investor, measuring opportunity against risk is critical. And for real estate investors in particular, risk is rising exponentially in the age of climate change.
To that end, big real estate firms are pouring significant resources into calculating climate risk and its likely effect on property portfolios — everything from increasingly extreme weather to a rise in sea levels.
"This process will be painful for investors who are caught off guard, but those who are prepared have the potential to outperform," a new report from the Urban Land Institute said.
Damage to U.S. real estate from extreme storms hit a record high in 2017. Natural disasters, including floods, mudslides and wildfires, cost more than $300 billion in damage, the bulk of it to residential and commercial real estate.
In 2018, from May through July, much of the East Coast, down to Florida, saw rainfall up to three times normal levels, according to the National Oceanic and Atmospheric Administration (NOAA). Nine of the top 10 years for one-day extreme precipitation events have occurred since 1990, according to the Environmental Protection Agency (EPA), because as the atmosphere warms, clouds hold more water.
All of these statistics are not just alarming, they are sounding the alarm bells for the real estate investment sector, because it is most vulnerable.
"Understanding and mitigating climate risk is a complex and evolving challenge for real estate investors," said ULI's CEO, Edward Walter. "Risks such as sea level rise and heat stress will increasingly highlight the vulnerability not only of individual assets and locations, but of entire metropolitan areas."
The report highlights how real estate investment companies are now prioritizing the risk of climate change and creating new approaches to better gauge and develop mitigation strategies.
"Building for resilience, on a portfolio, property and citywide basis, is paramount to staying competitive. Factoring in climate risk is becoming the new normal for our industry," added Walter.
Some of the strategies, according to the report, include:
"Investors see climate considerations as a necessary layer of fiduciary responsibility to their stakeholders, as well as an opportunity to identify markets and assets that will benefit from a changing climate," according to the report. "While early adapters have committed resources to gain knowledge and improve awareness of climate risk, in the coming years, methods are likely to become more sophisticated."
It also highlights the potential return on investment from putting resources into mitigation strategies for real estate assets.
Heitman, a Chicago-based real estate investment firm with nearly $34 billion in assets under management globally, worked with ULI on the report and is putting heavy resources, both financial and personnel, into measuring and balancing climate risk.
"The industry didn't seem to be pricing in these kinds of risks," said Mary Ludgin, senior managing director and head of global investment research at Heitman. "When we began the project of trying to identify the climate risk inherent in individual properties, we first looked to our insurers. They were less of a help than we were expecting."
That is because insurers reprice annually, and therefore do not look at long-term models. FEMA flood plains are reassessed about every five years, but they still don't account for the increasingly extreme weather and heavier rainfall that parts of the United States are now seeing.
"We can't try to determine what's going to happen in 12 months beyond, because insurance is set up for what your risk is today. And it wouldn't meet actuarial science to charge you for a future potential," said David Maurstad, FEMA's deputy associate administrator for federal insurance and mitigation and chief executive of the National Flood Insurance Program.
Heitman is, therefore, going beyond traditional insurance predictions to factor climate risk into its investments. It hired a Berkeley, California-based firm called 427, one of a new cottage industry of companies that assess climate risk to real estate. It's mission, according to the website, is to catalyze climate adaptation and resilience investments by enabling the integration of climate science into business and policy decisions.
"They were able to provide us an assessment of flooding, wildfires, wind-related disasters, and we can then aggregate that up to what is Heitman's total exposure globally or a specific client's exposure on the individual buildings they own. They can assess potential acquisitions and the risk that they represent," said Ludgin.
These risks include not just the destruction from individual natural disasters but business disruptions for property tenants and higher operating and capital costs caused by increased wear and tear on properties from more extreme weather.
As a whole, the industry needs to understand the pricing impacts of physical climate risks, and how climate change is likely to have a bigger impact on valuation in the future as asset and market liquidity are affected, the ULI report says.
And it's not just storms and sea level rise, but the potential higher costs associated with protecting cities and municipalities from both. In Miami, for example, the city is investing $200 million into resilience, installing pump stations and upgrading its infrastructure. Miami Beach is on track to spend twice that, raising sidewalks and seawalls. The money is coming from new bonds — voters raising their own property taxes to protect their property.
"Are taxes going to rise?" asked Ludgin. "We are looking at scenarios where taxes quadruple in the period that we hold the property. You can assume that federal, state, and local governments will play a role, and that means a climate in which taxes are likely rising."
All of it is a new and now necessary part of what real estate investors, developers and managers need to do to factor opportunity against risk.
"They are trying to think about how their portfolio is balanced and make sure they're not overexposed in a market that has more risk," said Walter. "Not redlining markets, but investors are trying to be thoughtful about the level of exposure to those markets."
That is because higher-risk assets will eventually see downward repricing, as the market redirects capital to locations and individual assets where it is expected to be better insulated from these particular risks, the ULI report said.
-- CNBC's Erica Posse and Lisa Rizzolo contributed to this report