Author: Martin Silber
On May 20, 2021, the Biden Administration issued an Executive Order (“EO”) that detailed significant actions by the federal government to address climate change risk and impact of climate change on both the private and public sector. The order communicated that its policy is “to advance consistent, clear, intelligible, comparable and accurate disclosure of climate-related financial risk… including both physical and transition risks.” Moreover, the Financial Stability Oversight Council (“FSOC”) is “to collaborate with the other board agencies to comprehensively assess the climate-related financial risk to the stability of the U.S. financial system and issue a report on any efforts by FSOC member agencies to integrate consideration of climate-related financial risk in their policies and programs—including the necessity of enhancing ‘climate-related disclosures by regulated entities’ and the government’s recommended implementation plan.”
This executive order action by the Biden Administration should have substantial, long-term effects on the commercial real estate (CRE) sector. Moreover, since the EO was issued, there have been several other key resulting actions. These responses included the release of the FSOC Report on Climate Related Risk, which concludes that climate change is an “emerging and increasing threat to financial stability” and includes four recommendations on how to proceed focusing on building capacity, gathering and assessing data and evaluating and requiring greater disclosure. In this article, we will explore the need for the Executive Order, its implications and its potential impact on CRE.
This EO can have a sizable impact on the financial system, and particularly the corporate operations of the commercial real estate sector, because they fall under the jurisdiction and regulatory framework of the FSOC. Treasury Secretary Yellen stated that she would work with those agencies “to improve climate-related financial disclosures so the government, regulated financial institutions and investors will have the data they need to be able to understand and evaluate climate risk.” The EO and the subsequent FSOC report signify that we need a better understanding of the financial risk that climate change may have on the world’s financial and economic system as a whole. For the financial system, climate-change risks can cause considerable depletion of market capital as a result of declining real estate and land asset values. Also, the FSOC report suggests that this approach may result in banks undertaking greater scrutiny of the impact of climate change in their underwriting (loan issuance) practices.
Physical and transition risks are the two primary categories for climate-related threats. Increased frequency and greater impacts of extreme weather events such as droughts, rising sea levels, floods, wildfires and heat waves resulting from greater levels of greenhouse gases are physical risks. The damage to infrastructure and property, such as the approximately $13 billion in insurance claims related to the 2020 California wildfires, fall within this risk category. According to the 2020 National Climate Report, “2020 was the sixth consecutive year (2015–2020) in which 10 or more billion-dollar weather and climate disaster events occurred in the country” and “the total cost of U.S. billion-dollar disasters over the last five years (2016-2020) exceeds $600 billion.”
In comparison, transition risks represent the need for a company to create policy and actions to achieve and operate in an era of increasing calls for net-zero emissions and decarbonization, where it will need to navigate compliance with a greater number of local laws, disclosure requirements and shareholder requirements. Transition risks are specific risks created by and impacted by market, policy, legal, reputational, technological and other risk factors. For example, companies that are operating in states making a commitment to switch to renewable energy or the implementation of benchmarking laws will be primarily affected.
Real Estate Sector Impact
The impact of these two risk types could have loans in excess of banks’ lending capabilities or original appraised values. First, the real estate sector’s cash flow could be drastically affected by the increasing insurance premiums (and deductibles) for properties impacted by climate-related risks. At this time, climate-related risks and associated properties are still being considered insurable by most insurance companies focused on CRE. However, climate-related risks will begin to impact the insurability and underwriting of the properties as reinsurers adjust their rates on the primary insurers for climate related losses (e.g. hurricanes), eventually resulting in higher annual premiums and deductibles to property owners.
Second, climate-related events could impact the capitalization (“cap”) rate. In commercial real estate, the cap rate is defined as the expected rate of return to be generated on a real estate asset (property), based on its net operating income. The cap rate could be impacted by factors such as the lower ability to insure properties, lower rental income, decreased ability to sell a portfolio of affected assets and property geographical risk. In other words, the cap rate, may be the key factor that will guide the reduction of the value of these assets.
Finally, there may be a substantial increase in the cost of capital, reflected in higher interest rates, climate related escrow holdbacks, availability of credit as banks begin to adjust their underwriting of portfolios and stricter loan covenants due to greater climate risk at specific properties. Transition risks will also have a larger role to play as companies respond to the shift in regulatory requirements at a local and regional level. Physical structures as well as the construction materials used may be evaluated and benchmarked to determine whether they are meeting standards and requirements.
In short, climate-related risks are likely to increase the frequency and impact of extreme weather events. Commercial real estate owners must evaluate and analyze data related to their portfolios to understand the climate-related risks – both physical and transition – that may result in exposure to their portfolios. The EO and the FSOC reports have provided additional clarity on the issues that federal regulators believe will affect CRE as it moves forward into the new reality of climate change. It focuses its four key recommendations and practices for member agencies, which are listed below:
Evaluate climate related risk, and use scenario analysis to understand the potential financial impact on their portfolios, and evaluate a greater need for regulation and disclosure
Agencies and financial institutions need to build capacity and the skillsets to enable evaluation and identification of risks
Better actionable data to respond to in both the private sector and in the federal government
There is a need for greater disclosure of risks by companies who are operating in the markets
CRE will be directly influenced by these recommendations, with the primary focus on improving actionable data. Great scrutiny will be placed on commercial real estate businesses to have a business plan the reflects physical and transition risks, including long-term scenario analysis, that could have an extensive impact on the operations and value of the portfolios.
In addition, commercial real estate businesses will need to have an actionable plan, based on identified risks, data management and analysis, that can be addressed through a companywide ESG program and alignment and participation with top ESG reporting frameworks such as GRESB and TCFD (Task Force for Climate Related Financial Disclosures).
Financial implications will most likely be noticed through financial institutions with greater loan covenants, less borrowing capacity, more time for due diligence on climate-related risks and scenario analysis on climate-related events. More importantly, government agencies and banking institutions will have greater requirements and needs for companies to track and control key data to evaluate, measure and verify climate-related actions in order to demonstrate its operational ability to manage the downside risk.
CRE company actions in response to climate risk will be directly and indirectly reflected in their ability to secure capital for on-going operations and long-term investments. Business leaders have the opportunity to implement strategy to put forth a strong ESG plan to demonstrate their commitment to long-term viability in leadership, operations and company culture. The commercial real estate sector must act now to evaluate for high-risk assets, review key risk mitigation strategies and take appropriate action to address these risks.
About the Author
Martin Silber, MBA
Martin currently serves as the Executive Director of Strategy and Technology for Verdani Partners. Martin has more than a decade of experience in the sustainability and the renewable energy sector, working in key roles in technology/data analytics, finance, and policy. Martin holds a B.S. degree in Economics, an M.B.A. focused on Entrepreneurship/Strategic Public Policy, and a M.S. in Tourism Administration focused on Global Sustainability.