stranded asset potential

Climate risk raises stranded asset potential

Summer 2017 prompts investors to scrutinize precariously located properties
Monday, September 18, 2017
By Barbara Carss

Fire and flood created an ominous backdrop for real estate investment in the spring and summer of 2017 as natural calamities engulfed or inundated billions of dollars worth of property in North America and beyond. Worldwide escalating tallies of damage from storms and drought-related phenomena are indisputably capturing the industry’s attention.

“If you’re in investments, you need to consider climate change or you’re not doing your job,” affirms Lisa Lafave, senior portfolio manager, real estate, with the Healthcare of Ontario Pension Plan (HOOPP).

Yet, as with most examples of how ESG (environmental, social, governance) considerations are applied to asset and property management, there’s a continuum of commitment across a very broad field of players. The Global Real Estate Sustainability Benchmark (GRESB) 2017 results — propitiously released during the brief lull between Hurricanes Harvey and Irene — show a growing group of institutional investors and REITs that are enacting sustainability policies with associated performance requirements, disclosing their portfolios’ green status and using ESG metrics to guide their own decision making. Even so, GRESB primarily benchmarks participating portfolios’ impact on the environment rather than the other way around.

“Few companies are really thinking about climate change from the perspective of stranded asset potential,” says Francisca Quinn of Quinn & Partners, a consultant on sustainability strategies who works with several of the Canadian GRESB participants. “One of the conventional responses has been: Well, you can just get insurance. I think we’re going to get to the situation, which we’re already seeing in the residential sector, where you can’t get insurance. So, what do you do so you don’t get stuck with an asset that is not insurable?”

Market preoccupations

There are signs that long-term investors are beginning to unload precariously located properties, but shorter term preoccupations remain enthralling. For example, not unlike the recent state of the regional topography, some real estate analysts are suggesting the glass is more than half full in Houston’s commercial/industrial market following Hurricane Harvey’s dramatic wallop.

CBRE projects heightened demand for light industrial space, hotel accommodations and multifamily rental units as residents recover from an epic storm and flood, refurbish damaged properties and replace destroyed belongings. Building material and appliance distributors are tagged as a lucrative new tenant base, while temporarily displaced companies looking for swing space are expected to fill in some of the 11.1 million square feet of sublease space that was available in the office sector at midyear.

This post-Harvey overview of market conditions, released two weeks after the hurricane rolled ashore, calls Houston’s approximately 214 million square feet of office inventory “mainly unscathed” with fewer than 40 of the total 1,200 buildings reporting damage. That fraction nevertheless holds some interest for Canadians since Canada Pension Plan Investment Board (CPPIB) is the pending owner of nearly 2.8 million square feet of office space in two commercial districts where flooding did occur — West Houston and Galleria — as part of its late June agreement to acquire the Parkway REIT portfolio.

In an August 30 statement, current Parkway management reported “only minimal damage” for which they expect insurance coverage “subject to a nominal deductible”, but there’s little guarantee the deductible will be so nominal next time there is a claim. Insurance is a large component of expected operating cost increases related to ongoing volatile weather trends.

Looming vulnerabilities

In a prescient discussion of potential investment risk in South Florida released about 14 months before Hurricane Irma hit, Bill Maher, LaSalle Investment Management’s North American head of research and strategy, outlined scenarios for increased costs, eroding lender confidence and an exodus of tenants in coastal areas where there is a high probability of rising sea levels. He also described investors as generally blasé.

“According to LaSalle Acquisitions, brokers are reporting that the risk of rising sea levels is not impacting sales of institutional assets,” he noted. “Insurance companies are becoming aware of this risk but have not broadly increased premiums since the typical policy period is only one year. Real estate investors do not appear to be pricing this risk.”

Beyond spiking premiums or outright loss of insurance coverage, property taxes could jump to help cover local governments’ flood protection costs while capital markets become standoffish. “Lenders could re-price debt in the market, hurting leveraged returns, or refuse to finance an asset because its flood zone changed,” Maher warned.

GRESB’s nascent debt survey, which just released second-year results, reveals somewhat similar insight from the 25 participating entities — including four banks and 19 private equity funds or mortgage REITs in the United States, United Kingdom and continental Europe — that finance real estate and underwrite commercial lending. Flood risk is identified as one of four major risk management considerations related to a property or portfolio’s sustainability (along with regulatory upheaval, threat of obsolescence and social conditions and expectations).

Lenders deemed to be making effective use of ESG lenses report that they are adjusting loan criteria to “minimize and/or eliminate exposure to current or future flood-prone areas” and underwriting “significant increases in flood insurance premiums”. To do so, they are employing GIS mapping of flood-risk scenarios along with portfolio monitoring techniques to project future changes in insurance eligibility or premium increases.

Resiliency experts say building owners/managers should be doing much the same thing.

“If you do not know what the risk exposure is of the assets in your portfolio, something is wrong. Particularly if the risk is foreseeable — and it is entirely foreseeable,” asserts Alexander Hay, an engineer and specialist in security and protection of critical infrastructure who has been working with Building Owners and Managers Association (BOMA) of Greater Toronto on strategies for commercial real estate to adapt to extreme weather.

Failing safely

As a starting point, owners/managers need to think about the key operational demands of their buildings and their contractual responsibilities to their tenants. From there, they can identify potential vulnerabilities and plan to respond.

For example, critical equipment housed below grade will be easily compromised in a flood, while inhabitants of urban North America’s ubiquitous glass-box residential towers will quickly feel the heat or cold if power failures shut down HVAC systems. Alternatively, from a contingency planning perspective, owners/managers could bolster resilience through passive design (in new construction), investments in off-grid power sources and/or forging alliances with operators of nearby commercial buildings to share emergency resources.

The goal is ultimately a building that can fail safely — that is, one that possesses the capacity to survive chaotic events in condition to quickly return to normal operations. Hay casts commercial buildings and their management structure as the ameliorating intermediary between building occupants and potentially calamitous forces outside. Accordingly, if those forces become more persistent, tenants will move away from risk toward stability.

“We’ve had extreme weather since Noah so it shouldn’t be a shock that some extreme weather is happening somewhere in the world. What is changing significantly is the value at risk,” he says. “Commercial real estate is becoming more and more important in whether or not a company survives. If you look at this with cold commercial interest, if the city becomes less resilient, the value of real estate drops.”

A one-two punch courtesy of Hurricanes Harvey and Irma has certainly raised awareness, with the estimated combined cost of the two storms currently pegged at about US $290 billion (CAD $354 billion). Yet, it’s no revelation. Rather, it’s a boost of momentum for adaptation and investment strategies that were already in motion.

“I can see sophisticated investors exiting investment funds where they don’t have faith that the investment team is looking at climate risks,” Quinn concurs. “There will be more capital migrating to the people at the front end of the bell curve. At some point, money will talk.”

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

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