Value in a time of climate risk: How owners can adapt

Year after year, natural disasters are increasing in severity and frequency. From fires and heat waves to hurricanes, monsoons and floods, extreme weather events caused $313 billion in global economic losses in 2022 alone. Commercial real estate owners and lenders are waking up to the ways that climate change can impact asset performance, and many have already identified climate risk as a critical investment concern.

Recognising the problem, however, is only the first step. To truly understand and manage climate risk, owners need an intentional strategy that first quantifies the impact on property value and overall portfolio risk, and then outlines strategic solutions in response. As such, climate risk has become an important metric of a property valuation analysis. Valuation professionals are isolating climate data to score a property’s risk exposure to climate change and illustrate its effect on both value and tenant demand.

“Traditional valuers would tell you it's all in the cap rate, or it's all in my opinion. We are deconstructing it and looking at the quantifiable aspects impacting the value of a property and drilling down into real specifics,” says Tyrone Hodge, Global Head of Risk Advisory at JLL. “This process demonstrates the true impact on real estate value and pinpoints important risk factors at the property level or across a portfolio so that owners can make informed investment decisions.”

Climate risks have a permeating effect on a real estate portfolio. Weather events impact the physical structure of a property and the appeal of a geographic market; energy efficiency has an impact on operational costs; and green ratings affect marketability and tenant demand. A climate risk analysis considers a broad spectrum of environmental data to assess the various ways that climate change and sustainable building practices can affect property performance. This includes taking into account the frequency of natural disasters, sea level rise, rising temperatures and air quality as well as potential impacts on infrastructure and livability.

Sustainable building practices are an important starting point to reduce climate risk exposure. The benefits of sustainable building advance environmental investment strategies. Research shows that green buildings improve investment fundamentals, as they are more attractive to tenants and command premium rents. “JLL has done studies showing that increased occupancy rates and increased rents correlate directly to an increase in the sustainability of properties,” says Emily Chadwick, Head of ESG Risk EMEA, Value and Risk Advisory at JLL. “This has a net-positive effect on property value, resulting in a capital value premium of up to 20% in some markets.”

Climate risk factors affect a property’s value in both the short and long terms. A property in a market with high fire activity, for example, could face receding demand dynamics that affect exit strategy, or a property in an area with increasing frequency of extreme weather events that result in flooding could lead to costly and continuous physical damages to the property and possible erosion. A climate risk assessment looks at ongoing weather events to identify these individual risk factors and quantify the subsequent impact on asset value.

Proactively quantifying climate risks can also give investors an opportunity to take action and prepare. By understanding climate exposure, owners can acquire assets that meet internal objectives or make modifications to existing properties to reduce risk across a portfolio. Building upgrades can fortify structures to enhance resiliency during extreme weather events, and improving a property’s energy efficiency and water consumption can reduce the environmental impacts that perpetuate these hazards.

Assessing climate risk shouldn’t be a one-time evaluation, but rather it should be an ongoing component of active portfolio management. Hodge says that monitoring the climate risk of an existing portfolio has become increasingly common as owners have a growing need to understand their current exposure. “Pre-purchase is important, but if you have a book of assets or if you are planning to sell, then you have a lot of interest in understanding the risk,” he says. JLL recently performed a risk assessment for a retail owner looking to sell. The assessment revealed that the property had significant flooding risk, and the owner was able to make property improvements before marketing the asset to preserve the investment return.

Regular risk assessments are particularly important because climate change, and the risks from it, are anything but static. Climate risks are constantly evolving and changing. Each natural disaster and severe weather event has a unique impact on a geographic market and changes the risk calculation. In some ways, major weather events illustrate how climate risk is a moving target. The number of extreme weather events in 2022 exceeded the 20-year average by 25, and that number is only expected to increase. As a result, investors failing to keep up with climate risk will almost certainly—and in some cases, severely—misjudge their true exposure.

In response, valuation and risk experts are also continuously improving the process of analysing climate risk to incorporate the most relevant and recent climate data. “The data has to evolve so that an investor can see the changes in risk over time and the impact on value,” explains Hodge. “We are analysing multiple sources of climate and property data to construct our own method and provide timely insights to investors.”

Due to the increasing frequency of natural disasters and extreme weather events, climate risk has become an essential metric in a real estate risk assessment and investment underwriting practices. In the face of unpredictable and uncontrollable climate change, owners that are closely monitoring these events and working with a team of advisors can properly measure risk exposure, protect investments and stabilise asset values.