Assessing the climate change risk in real estate

An increase in frequency and severity of weather events has triggered a heightened awareness and information demand to better understand climate related risks, particularly for assets with a long lifespan like real estate. More refined modelling techniques are helping investors to better assess the risk exposure of properties.

Scientific evidence

Since the pre-industrial period, human activities are estimated to have increased the earth’s global average temperature by about 1 degree Celsius (1.8 degrees Fahrenheit), a number that is currently increasing by 0.2 degrees Celsius (0.36 degrees Fahrenheit) per decade, according to data by NASA (opens a new window)

The rising global average temperature is associated with widespread changes in weather patterns. Scientific studies indicate that extreme weather events such as heat waves and storms are likely to become more frequent or more intense, according to the United States Environmental Protection Agency (EPA) (opens a new window)

Scientists expect (opens a new window) that the frequency and intensity of convective storms will change as the climate warms. As a result, flash floods are likely to become more frequent in future (opens a new window). In other regions, rising temperatures are likely to increase the frequency and severity of wildfires.

Effect on real estate investments

An increasing incidence of catastrophes can drive up insurance costs and consequently lead to under or no insurance. This may impact the creditworthiness of investors and lead to default rates in highly exposed areas.

Four Twenty Seven, an affiliate of Moody’s and a leading publisher of data and analysis relating to physical climate and environmental risks, has scored over two million corporate facilities according to their forward-looking climate risk exposure. The results showed that 18% of the facilities scored in the UK are highly exposed to floods. In Spain, 22% of the facilities scored are exposed to wildfires. Four Twenty Seven assesses data on six physical climate hazards: heat stress, water stress, slides, sea level rise, hurricanes/typhoons and wildfires. Looking at such data and information may not always avoid risk but can certainly help in mitigating it. Lockton and Four Twenty Seven have entered a partnership (opens a new window) that makes climate-related data available to Lockton clients.

It's not only buildings that are at risk of weather events. There is also the possibility that highly exposed areas or regions face a decline in land values as the effects of climate change are priced in. Climate change related events can not only cause expensive damage to real estate assets, but also lead to increasing costs for operations and higher average temperatures lead to rising energy costs over time. Chronically inundated roads or regional highways disrupt transport systems for the population, as well as goods. Wildfires can also cause disruption over large areas as the smoke spreads over hundreds of miles, creating rippling dynamic impacts that need to be better understood. Climate-related weather events can decrease the value of real estate assets or even render them unusable. Furthermore, weather-related events can not only cause physical damage but also have an emotional/psychological impact.

Climate-related risks can also create balance sheet volatility for investors as these are reflected in revenues and losses, potentially coupled with increased capital requirements. 

Banks are also increasingly looking into weather risk modelling, not least because central banks are concerned about the resilience of the whole financial system. In March 2021, the European Central Bank (ECB) released the results of its climate stress tests looking 30 years into the future and covering about 4 million companies globally and 2,000 banks. In a blog summarising the results (opens a new window), Luis de Guindos, Vice President of the ECB, said that climate change represents a major source of systemic risk, particularly for banks with portfolios concentrated in certain economic sectors and geographical areas. Physical risks differ across countries and regions, with southern Europe on average more susceptible to heat stress and wildfires, while central and northern Europe are more vulnerable to flooding. A senior executive reportedly said (opens a new window) the ECB was prepared to raise the amount of capital required at any banks considered to have particularly high levels of climate risks in their balance sheets as early as this year.

Accurately predicting weather events

Research indicates that traditional climate models tend to underestimate (opens a new window) average rainfall changes in winter, where wintertime convective showers causing high precipitation in a small area for a short period of time are a key factor.

Accurate projections of convective weather requires “high-resolution” climate models (opens a new window). A new generation of climate models is capable of providing more precise projections for changes in high-impact weather extremes such as short-duration heavy precipitation. Research shows (opens a new window) that summertime hourly rainfall is intensifying more than previously expected and has also shown significant variations in the frequency (opens a new window) of exceeding key flood alert thresholds.

More accurate high-resolution models are also providing new information on future changes in wind extremes and so-called “sting-jets” (opens a new window) that cause very high wind speeds like those found in some cyclones. They are responsible for some of the most damaging surface wind gusts (opens a new window), such as the UK’s Great Storm of 1987 (opens a new window).

Opportunities for the real estate sector

Understanding the risk for real estate means looking 20 to 30 years ahead through weather modelling to quantify the likelihood of an event and the likely effect on a property. While quantifying the potential damage requires significant computing power and plenty of data, for example from governmental agencies, Artificial Intelligence (AI) can help refine and facilitate the process. Furthermore, the Internet of Things (IoT) is an important piece of technology to measure the effect of weather events and deliver the trigger basis for parametric insurance claims. 

Companies, investors, and even individual property owners can use the information gained on the effect of climate change to take smart decisions and refine their investment and protection strategies. This can, for example, lead to risk mitigation through the use of more suitable building materials, new types of architecture design, or by building protections; for example in form of flood barriers. Further, intelligence can lead to building or investing in areas where the risk is lower. This can help reduce claims and contribute to lower interruption and more resilience. For investors, the modelling data can also help finding out how a portfolio might depreciate and how this can be avoided. 

Back in March, we hosted a panel discussion with Concrete VC (opens a new window)FloodFlash (opens a new window)Four Twenty Seven (opens a new window) and Zurich (opens a new window) where we discussed the physical and economic risks linked to climate change and ways to increase resilience towards these risks. Watch a full recording of the webinar here (opens a new window).

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