Top 4 Reasons Limited Partners Should Consider Climate Risk

In a high interest rate and expanding cap rate environment, real estate investors and partners must work harder for returns. One way that limited partners can keep competitive is by leveraging location analytics to measure physical climate risk and resilience.

Physical climate risk refers to the potential damage caused by natural disasters such as flooding, wildfires, and hurricanes, whereas climate resilience refers to the ability of a location to withstand climate shocks and stressors.

Limited partners can benefit by using location analytics to screen prospective investments for climate risk and better understand which general partners are over exposed to climate perils. Additionally, location analytics can help align partner interests within co-investment vehicles, by establishing more transparency into the potential impact of climate change.

In the case of pension funds and life insurance companies, which are bound by fiduciary duty, climate analytics can help them deploy capital more prudently on behalf of beneficiaries.

Here are 4 compelling reasons why limited real estate partners should incorporate climate risk and resilience into their capital deployment strategy.

Direct Damage from Extreme Weather

Each year extreme weather causes billions of dollars of damage to the real estate industry. In 2021 the world’s largest reinsurer, Munich Re, incurred $120 billion of insurable losses, representing the second most costly year on record. However, insurable losses represent only a small portion of total losses, estimated to be $280 billion in 2021, with real estate owners and investors coming out of pocket for the remainder. However, extreme weather not only results in costly property repairs but also disrupts business operations. A study performed by First Street and Arup estimates that flood damage to commercial buildings in 2022 resulted in 3.1 million days of lost business operations.

Since total losses from extreme weather have quadrupled over the past decade, property insurance and other carrying costs have also soared to unprecedented levels. For real estate partners, extreme weather represents one of the largest threats to sustained profitability.

Coastal Market Devaluation

There is growing evidence that climate risk in coastal markets, which are susceptible to storm surges and flooding, has already affected residential real estate prices. More specifically, a 2018 study performed by Pennsylvania State University and the University of Colorado indicated an average 7% “sea-level-rise discount” for non-owner occupied coastal residential properties. Similarly, First Street Foundation released data showing that eight states lost a combined total of $14.1 billion in coastal home value since 2005 due to sea-level-rise flooding. As limited real estate partners look to deploy capital, they should take note of the valuation disruption already underway within residential coastal markets.

Climate Migration Creates Resilient Opportunities

Climate migration is the relocation of people due to the environmental, social, and economic consequences of climate change and is already occurring all over the world. The Internal Displacement Monitoring Center predicts that approximately 14 million people will be displaced every year due to acute weather (hurricanes, floods, and fire). Furthermore, almost every country will experience climate migration — even North America and Europe. For example, the Center for American Progress collected data that highlights the impact of Hurricane Katrina (2005) on migration patterns along the Gulf Coast. Of the 1.5 million people who evacuated Louisiana in advance of Katrina, roughly 40% had not returned to their pre-storm, former residence after a decade, 15% stayed within 10 miles of their former residence, and roughly 10% relocated more than 830 miles from their former residence. The migration triggered by Hurricane Katrina serves as a poignant example of individuals moving out of climate stressed communities and into resilient ones permanently. As people move, the businesses that employ them will also likely move — underscoring the importance of resilient geographies.

As population dynamics change in response to climate, new real estate investment opportunities are likely to present themselves, particularly in the locations that are best able to manage climate shocks. These locations will likely be characterized by infrastructure, healthy public budgets, and quality healthcare systems. Savvy real estate investors and partners should take note of current and future migration patterns in order to capitalize on new investment opportunities.

Climate-Related Risk Regulation

Globally, an increasing number of jurisdictions are introducing rules and taxonomies governing climate risk disclosures. In 2015, the G20 established the Task Force on Climate-related Financial Disclosures (TCFD) to provide guidance on how to disclose climate-related risks and opportunities to investors and stakeholders. Currently, TCFD is set to become required by regulation in the E.U., U.K., New Zealand, Singapore, Canada, Japan, and South Africa. In the United States, TCFD is not required by law, but is commonly incorporated into financial risk management practices. Moreover, global institutional investors require these disclosures from the funds and ventures they invest in.

To consolidate sustainability disclosure requirements across different countries, the International Sustainability Standards Board (ISSB) was established by the International Financial Reporting Standards (IFRS) board in 2021 to create a universal rule. In June 2023, the ISSB released new rules which simplify climate-related disclosures and eliminate the need for redundant reporting. The new rules represent an important step towards integrating climate risk into financial reporting and will begin to influence how and where global real estate investors and partners invest.

Overall, incorporating climate risk and resilience in the investment process is important for real estate limited partners who seek to minimize risk, maximize value through prudent capital deployment strategies, and stay ahead of climate related risk regulation.

For more information on how AlphaGeo can help you get ahead of the impacts from climate volatility visit our website at www.climatealpha.ai.

Originally published September 2023