Safe as houses? Global real estate exposed to the elements
An age-old assumption is that carefully-selected real estate will be a safe harbour in the face of market volatility. Given extreme weather events like flooding, cyclones, sea level rises, sustained heat waves and hail storms, this assumption may not hold.
Extreme weather patterns can fundamentally change the value of real estate. In the most severe cases, volatile weather patterns can destroy property.
These are important themes for self-managed super fund (SMSF) investors to understand when thinking about the construction of their portfolio.
Climate change and this weather volatility present a challenge for investors. There are the physical impacts of climate change, as well as indirect impacts relating to the shifts in rental demand and asset values.
Regulatory risks from governments targeting carbon emission reductions and the availability of capital are also important considerations. This article explores the complex melting pot of risks and opportunities in global real estate.
Being green pays
Buildings use significant natural resources, including water and energy. Concerns about the use of these resources are mounting, and regulators are pressuring the real estate industry to invest in technology that delivers water and energy efficiencies.
The question building owners traditionally ask is, ‘do green buildings pay?’
When it comes to new constructions the answer is yes. Buildings with leading edge water and energy efficiency technology are marketed as premium buildings.
Additionally, large government and corporate tenants tend to expect the buildings they use and own will be energy and water efficient. These organisations set environmental targets and commit to reporting on their progress.
For old buildings, it is a more difficult equation. Retrofits can be capital-intensive and tenants will not always pay more for environmental credentials. But in the next five to 10 years, most buildings will need to meet minimum environmental standards.
Building owners who delay retrofits will only make the inevitable more expensive. They will find capital more expensive to access, as banks expect minimum environmental, governance and social (ESG) credentials before lending, and investors seek to protect themselves from stranded asset risk.
The empirical evidence
During the past five years, there has been a debate about whether sustainability translates to higher returns. Before considering the data, it is worth highlighting that the findings should be interpreted with caution given a property’s sector, location and age can significantly impact rent, vacancy and value.
- In a 2014 Cambridge University study, return on equity (ROE) was shown to increase by roughly 3.4% for each 1% increase in the Global Real Estate Sustainable Benchmark (GRESB) score, while return on assets (ROA) increased by 1.3% for each 1% increase in GRESB score.
- Assuming an average annual 5% ROA and a GRESB rating of 50, a GRESB score of 55 (10% above baseline) is associated with a 0.67% lift to ROA. A GRESB score of 60 (20% higher) yields an ROA that’s 1.33% higher.1
- A survey conducted in 2015 by CBRE, the University of California, San Diego, and McGraw Hill Construction found building managers saw a significant improvement in tenant satisfaction after green updates. The same study found that Leadership in Energy and Environmental Design (LEED)-certified buildings have higher occupancy and rental rates. Rental premiums range from 4% to 13% for Energy Star certified commercial buildings.
- A 2014 survey carried out by National Association of Real Estate Investment Trusts found total project investments in a small sample of energy-efficiency initiatives amounted to US$105 million, while these projects saved US$40 million in energy costs in the first year alone, providing an overall return on investment of 40%.
Implications for investors
As investment managers, AMP Capital reviews the environmental credentials of every real estate entity before it invests.
This makes financial sense: new buildings need to be energy and water efficient to attract and retain premium tenants and existing buildings need to be retrofitted to minimise stranded asset risk.
In Australia, there is a significant opportunity to review and update the building stock to account for ESG risks and opportunities.
1University of Cambridge, 2014, The Financial Rewards of Sustainability: A global performance study of real estate investment trusts.