Climate risk infuses real estate investment agendas

Climate risk infuses investment agendas

Canadian commercial real estate markets exhibit some locational advantages
Tuesday, March 2, 2021
By Barbara Carss

Canadian commercial real estate assets are comparatively less exposed to the dire physical threats that extreme weather poses or has already served up in other global regions. Industry insiders suggest that could make the COVID-19 pandemic an even more instructive trial run for the ancillary risks the sector is likely to face due to climate change. Brewing calamities will bring economic and social upheaval far beyond their meteorological track, and a growing pool of investors is looking for evidence that asset and property managers are prepared to respond.

“2020 was a year that saw ESG (environmental, social, governance) reporting move to centre stage. In the same way that, 15 years ago, discussion around LEED certification really morphed from ‘Should we do it?’ to ‘It’s the new norm’ so, too, will ESG reporting become a permanent component of our industry,” observed Paul Morassutti, vice chair, valuation and advisory services, with CBRE Canada, during last week’s online release of the firm’s 2021 Market Outlook. “Let’s talk about how climate risk could impact underwriting and even capital flows. Every institutional investor pays very close attention to the reversionary value and their ability to exit in 10 years, 20 years or 30 years. It (climate risk) will absolutely be on everyone’s radar by then, which means it should probably be on ours now.”

Turning to those institutional investors, MSCI analysis estimates that 6 per cent of the value of the Canada Property Index, or nearly $9.5 billion worth of directly held assets, is vulnerable to the physical forces of climate change or the related stresses of an imperative transition to a low-carbon economy. Speaking during the virtual results presentation of the index’s 2020 investment returns last month, Bryan Reid, executive director of real estate research with MSCI, outlined how the index currently scores on two separate risk matrices.

These matrices gauge: the potential for on-site physical damage and/or operational disruptions tied to the occurrence of an extreme climatic event; and the economic costs and regulatory constraints that could come into play to meet emission reduction targets and other required responses to a climate crisis. Results are then combined to tally the total value at risk.

Overall, Canada’s global latitude and roster of inland cities serve it well. Across the entire index of 2,356 assets predominantly dispersed in nine major urban centres, the vast share of value at risk — nearly 5 per cent of the index’s capital value — is attributable to transition factors.

Favourable physical risk profile comes with transitional unpredictability

Assets located in Halifax stand out for a higher degree of physical risk, equating to nearly 10 per cent of asset value exposed to the possibility of coastal flooding and/or tropical storms, while Vancouver ranks as the next most vulnerable host city with just less than 5 per cent of value at risk to coastal flooding. In contrast, assets in Toronto are most insulated, with 4.43% of value deemed at risk and less than 0.5% of value at physical risk.

“The physical risk for Canada is pretty low relative to some other countries. When we run other countries through this model, what we tend to see is that increased coastal flooding, fluvial flooding and tropical storm risk are the highest drivers of physical value at risk,” Reid reported. “In terms of extreme heat, the potential temperature rises aren’t as high (in Canada) as in some of the other more southerly locations so the costs associated with cooling buildings is not as high as what we might see in places like Phoenix. In fact, the lower prevalence of extreme cold days (with climate change) is also likely to offset a little bit and reduce the running costs of some of the assets.”

Reid characterizes the physical risk analysis as a “high-level snapshot” and notes that additional risks may emerge that will need to be weighed. Morassutti leans to an upside interpretation.

“If you look at any list of the global cities that are most vulnerable to either coastal flooding or warming, you’ll see many familiar places: New York; London; Miami; Boston; Phoenix; Hong Kong; Shanghai; Tokyo; but no Canadian cities,” he reiterated. “That is not to say that we will not be impacted. We will, but the effects of climate change will not be felt evenly. That may result in a recalibration of how global capital views those markets, and that may very well be to the benefit of major Canadian markets.”

However, pointing to other trends outside Canada, Colin Lynch, head of global real estate investments with TD Asset Management, reminded investors, owners and managers that transition risks could arise with little advance notice. “In 2019 and 2020, we’ve seen governments make regulations in reaction to a lot of social pressure around real estate, and that is something that we all have to be cognizant of going forward,” he reflected during last month’s panel discussion on the Canada Property Index investment results.

ESG underscores goals and maps progress for investors, asset and property managers

ESG is steadily gaining traction as a means to steer investors and guide asset and property managers on both physical and transition risks. Also contributing to the panel discussion, Deborah Ng, head of responsible investment and director, total fund management, with the Ontario Teachers’ Pension Plan Board, maintained that both groups have already successfully subscribed to ESG benchmarking and reporting so the next steps are simply to stretch those applications further. She identifies net-zero carbon emission as the logical goal post for quantifying transition risks, while urging more contingency planning around physical risks.

“Real estate made a link between sustainability and managing energy and water use very early on because it was a value driver; because it attracted and retained tenants and actually resulted in the ability to command better rents. There is a lot of empirical evidence to support that,” Ng asserted. “The gaps are in thinking about transition — how are properties preparing themselves for potential regulations to be net-zero or potential pressures from tenants so the tenants themselves can achieve their net-zero goals? — and thinking through physical risks and how they impact property, whether that’s flooding or increased heat that’s going to require more HVAC.”

Ontario Teachers’ and its real estate arm, Cadillac Fairview Corporation, use hazard assessment modelling for the latter exercise to derive 10-, 20- and 30-year projections of the gamut of extreme climatic events that could potentially engulf each asset. Meanwhile, Ng warns that investors and property/asset managers will likely have to respond to regulatory dictates and absorb transition costs sooner still.

“COVID was disruptive for sure, but net-zero and the transition to a low-carbon economy is going to be incredibly disruptive for real estate. Looking forward, there needs to be a lot more understanding from real estate managers of embracing technology. How do you harness technologies — smart metering, battery storage, deep lake cooling — to make buildings more sustainable?” she said.

Ng frames ESG as an increasingly critical tool to both support investment decisions and hold asset managers accountable. “We’ve seen a lot of disclosures — what’s being tracked? what’s being monitored? what’s being targeted? Now, there’s going to be a lot more focus on performance, and how that performance compares relative to peer groups or relative to this low-carbon or net-zero trend mission that is underway,” she submitted.

“Despite the fact that investors are having to deal with a lot of short-term challenges now as a result of COVID, they really haven’t lost any focus on the long-term climate risk. In fact, I’d say that over the last year we’ve even seen increased interest in profiling and understanding climate risk,” Reid concurred. “There isn’t a trade-off between near-term and long-term risks. Risk management is definitely getting a lot more scrutiny across the board.”

Barbara Carss is editor-in-chief of Canadian Property Management.

Leave a Reply

Your email address will not be published. Required fields are marked *