Institutional investors are increasingly using readily available risk data to understand the actuarial implications of increased number and severity of hail storms, wind storms, hurricanes and other climate events and their impact on property values. Many REITs and sophisticated investors have exited markets with increasing risk, and sold out to retail syndicators.
During this Multifamily Innovation Conference – Atlanta (MICA) session with Laura Craft, SVP, Head of Global Strategy & Investment ESG at Heitman, she addressed sources of risk data that everyone in the industry can use to understand the changing investment and operational environment; pricing and investor trends in affected markets; and insurance and other risk management strategies for investors committed to these markets.
Heitman is a real estate investor with over $40 billion in investments and incorporates ESG (environmental, social, governance) into investment decision-making.
“ESG can be a confusing thing to many,” Craft said. “It can be referred to from an investment strategy and/or from a company perspective of company culture and organization.”
Defining ESG Investment
A company’s ESG profile is based on its goals and policies pertaining to the company’s own environmental footprint, HR policies and compliance committee practices,” Craft said.
At MICA, she rather focused on ESG’s investment propositions, which is related to things such as Net Zero goal, reducing emissions and climate change. Heitman seeks sustainable operations in resilient locations.
According to Heitman’s website, corporate social responsibility represents investing today with a focus on tomorrow. Its investment process carefully considers ESG principles. In executing client mandates, it seeks to improve the world in which we live and work, while delivering the investment outcomes our investors require.
Embedding ESG considerations into its investment and management processes provides opportunities to create value, reduce risk and enhance investment returns for its clients. Heitman’s Global ESG Committee oversees the process in which ESG considerations are implemented in into the various investment strategies managed by our global private equity, debt, and securities businesses. The ESG Committee is an interdisciplinary group.
Its goals are articulated as follows:
Environmental: Assess environmental exposures associated with the location of investments and improve environmental resource efficiency through operational best practices, including implementation of innovative technologies and strategies.
Social: Operate such that all investment decisions align with our firm’s values and that these values are transmitted through our employees to the stakeholders associated with our investments.
Governance: Uphold strong ethical and corporate governance standards through transparency and integrity, and by working or investing with firms that have demonstrated the same.
‘Will I Be Insured and Will Climate Impact Mortgage?’
Natural disasters are increasing. Insurance claim costs have doubled in the U.S. to $95 billion the past year.
“We went through the alphabet in the hurricane naming process last year, and had to start using the Greek alphabet,” she said. “The largest wild fire on record occurred in 2020.”
Craft said one of today’s leading questions for owners and investors is, “Will I have insurance for that?”
It becomes a bit tricky, she said, because insurance is based on a one-year time horizon and insurance companies use historical data to determine policies. That strategy doesn’t align for companies that have a 5- to 10-year investment horizon. Insurance protects against physical damage and not loss in value.
“So, we need to think of the risk and how insurance costs will change during that time horizon,” she said.
Additionally, Craft said that last year, for the first time, she saw lenders increase rates based on market-level climate risk.
“Their portfolio was overexposed, so they wanted to cover that risk,” she said. “Lenders are trying to model climate risk better; Hurricane Harvey caught a few lenders off-guard as a lot of properties damaged were not in a FEMA flood zone, yet they flooded, and they did not have flood insurance. Because climate events keep happening, lenders are paying more attention to climate risks and we’re seeing a few adjust rates to account for the additional risk.”
FEMA records are binary in nature, so its data is less reliable and outdated. So instead, we use this as a third-party data source.”
The 100-Point Scoring System
Heitman uses a 100-point screening score on an entire portfolio for climate risk by taking into account flood, wildfire, hurricane, heat stress, water stress and sea level rise.
It’s not just about looking at the coastline, though. “You have to take into consideration that the lower lying areas might be further inland and at a greater risk,” she said. “You need to understand the market risk. A property might not have risk, but it could be located in an area that does have risk.”
She said that investors who know they are in a risky area will want to understand the surrounding infrastructure such as the roads, power grids and implemented climate mitigation.
Craft spoke often about how climate risks are factored into investment decisions.
“We look at the cash flows, discount rate and exit cap rates,” she said. “Investors may factor in lower cash flows to cover rising operating costs and higher rates to factor in higher level of risk related to climate. All of these adjustments can translate to lower property values.”
“Additionally, when climate events occur, migration patterns can be affected, potentially leading to negative net migration for an area after a climate event.” Declining population patterns lead to less renters in a market, “and rental revenue could decline and bring about lower net operating income and property value,” she said.
Key Portfolio Considerations
Cities and their building infrastructure can help to mitigate risk.
When looking to create or add to a portfolio, climate risk needs to be factored in, Craft said.
“Does a given asset have risk?” she asked hypothetically. “How much risk does the overall portfolio have? You don’t want to be over-exposed. What kind of resilience has been put in place to mitigate the risk?”
Governmental or developmental resiliency can play a significant role when measuring potential risk.
If all things are equal, Craft said, a property in a flood zone in Holland might be a wiser choice than one in the United States because Holland has invested heavily in resiliency measures to protect against flooding.
“When investors focused on climate risk are looking at investments to acquire with climate risk, these properties are scrutinized in committee discussions compared to those that don’t,” she said. “These deals require more due diligence and onsite investigation.”
She said Heitman and other firms, during new development, structure in climate mitigation features. “If we knew the development had risk and we could protect our investment through resilience measures, we’d build it in,” she said. “There is a return on that investment.”
Mill Creek Residential, for one, raised the main entrance to one of its buildings in Miami to the second floor, 12 feet above the flood zone. This can make a building more attractive to prospective residents.
Craft said investors must also look to see if the streets are elevated; or will they flood easily? “You need to think about the surrounding infrastructure such as bridges near the property, she said. “Our property may be safe, but are the bridges to get people there going to be underwater?
ESG considerations have come a long way.
Craft said that five years ago, upon looking at climate risk analysis, investment teams were asking: “What does all of this mean? But now, when these scores are high, it’s easier to understand why.”
Here is the replay:
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