In September, together with Tishman Speyer, we co-hosted a Roundtable lunch and discussion at the Rainbow Room in the Rockefeller Center. The food and the view were fantastic! It was an invite-only affair for eight real estate investors and investment managers. The topic of conversation was climate risk and how it can effectively be integrated into investment decision making; looking at the differences between the European and the American markets.
“Looking at Europe is like a glimpse of the future – what is happening there now will come to the USA in 5 years or less.”
For any US investment manager raising capital from Europe, they are being faced with ESG questions from investors and sustainable finance regulators. There is an expectation in the US that ESG is here to stay. The US market is having to learn fast, but there is a big gap between the leaders and the laggards. Some ESG themes are seeing greater adoption than others, like Net Zero Carbon and transition risk. This is flowing down from corporate and fund strategies into individual asset plans. It has placed an unprecedented demand on the relevant technical expertise. Diversity, Equity & Inclusion (DEI) has been a priority for the US for a long time and has required a more sophisticated and integrated response than it in Europe.
“We’d never not do a deal because of climate risk.”
There is still a gap between acting on ESG and an acceptance that it will materially affect transactions. However, there is anecdotal evidence that US deals have been stopped and prices have been chipped as a result of European investor concerns about climate risks. One European Core+ fund factored in the transition capex over 20 years and used that to reduce the price paid. Another pulled out of deal during the final stages of DD because the power grid feeding the property was not decarbonising at a fast enough rate.
No-one is monitoring this impact on the real estate market in a systematic way so there is a lot of speculation about which local markets will be affected. Some high risk markets, like flood-prone Miami, do not seem to be seeing demand or prices decline, although there is some evidence that transactions are taking longer. In other US seafront locations, there are other indicators that a future price correction or increased illiquidity might occur, such as increased mortgage and loan default rates.
“Two hold periods: nine years is today.”
Investment managers are thinking ahead in terms of what a Core fund might be looking for when acquiring an asset from a Added Value fund: Will they tolerate increasing climate risk, such as high operational energy costs and carbon emissions due to poor building fabric and inefficient equipment? If more climate change has occurred, will flood, fires and storms become more frequent or more extreme?
That perspective of two hold periods and different attitudes to risk can bring future climate risk considerations back to the present day. Getting the right information from risk models has proved difficult, with multiple vendors providing different answers for the same assets and locations.
“If you’re serious about ESG, it shouldn’t be in an appendix in the IC memo, it should be upfront.”
ESG and climate risk is being integrated into DD and into IC memos. This is occurring in different ways, both quantitative and qualitative. With some firms factoring climate risk into financial models by adjusting the cap rate, as a proxy for increased risk, or adjusting the cash flow to factor in increased transition costs. There is no standard approach, making it difficult to price climate risk into real estate transactions. However, if exit prices are getting chipped then more leverage is required on the buy-side if the required risk-adjusted returns are to be achieved.
Not all of the guests saw climate change as a risk, they also saw accretive opportunities for some assets. If you know what needs to be achieved, then risk-adjusting your under-writing can be more impactful. Instead of a divestment strategy.
“We’re not worried about how much insurance will cost, but whether there will be insurance.”
One developer-operator was concerned about the direction that the insurance industry is taking. In some locations, policies are not being written, even when the location has a high economic resilience and the wealth to adapt to some change. The problem was seen as the insurance sector being backwards looking using historic models. Others felt that these policies couldn’t be packaged for re-insurance. There was a desire for more nuance, particularly for unique assets like data centers.
“The question of whether there should be a carbon price has been overtaken by energy prices.”
Opinions were split on the value of having a carbon price, which could be introduced through fines, like in NY Local Law 97 or through carbon taxes like the new one in Demark. An internal carbon price could also be adopted. There was a view that the Ukraine war, and historic underinvestment in energy security through renewable energy and energy efficiency, has precipitated a very high energy prices which is already driving different decisions without needing a carbon price. Making it easier to justify investment in assets to decarbonise portfolios. Some owners have wanted to help tenants who are struggling to pay by aggregating their demand and using collectively buying power, but the aggregation has proved too hard.
“An empty building is an unsustainable building, so who’s measuring whether climate risk is making a building empty?”
Looking back to the UK, properties are laying empty as businesses have to close down because they can’t afford their energy bill. It is going to cost the UK government about £170bn this year to help those who can’t pay. This is a transition risk because it has been partly caused by conditions created historic underinvested in building energy efficiency and renewables, with the invasion of Ukraine tipping the balance. For real estate investors, these voids compounds the challenge of re-upping leases following the pandemic and sustained hybrid working.
In the US, better data does exist on energy consumption, in some locations where there are legal requirements to disclose annually through Energy Star. This makes it possible to benchmark properties and understand relatively efficiencies. It can show which ones are more exposed, requiring greater capex, and whether it could effect rental income and yield.
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