Owen Woolcock and Rajeev Ranade, partners at real estate investment firm Climate Core Capital, believe there is a reckoning coming to real estate values, and it has very little to do with the current interest rate environment. Rather, their view is shaped by the fact that there are compounding risks related to climate change that will undermine performance, across both asset classes and geographies.
The duo founded Climate Core Capital in response to their observation that real estate assets are mis-priced because investors are generally backward looking, and don’t adequately factor future climate-related risks into their criteria. While current assets may be performing as expected today, the firm expects natural disasters and other issues like droughts and extreme heat to force a re-pricing in many markets. As a result, the investment firm allocates capital to best in class developers and operators of real assets in markets least exposed to these risks. They have advised on transactions totaling over $215 million of value to date.
Ranade explained. “Much of America is at a nuisance level of climate risk, but there are markets outside that, which are at risk and getting riskier. Where Climate Core plays are the highest readiness and lowest risk markets. This is where we believe capital can thrive alongside recurring climate risk.” The firm targets a 17% IRR, with a standard 5-8 year hold period. Historically, 70% of projects have been focused on development, with the remaining balance in core plus assets.
Perhaps because the topic of climate risk is complicated, highly politicized and often met with skepticism, there is a tendency for many investors to de-prioritize or ignore it. Woolcock argues that because the risks are accelerating at an unpredictable pace, investors no longer have such a luxury. “Our efforts to reduce emissions have not matched the urgency of forecasts,” he said in a corporate webinar. The impact of global warming has arrived. Once upon a time, we might have only needed to mitigate. Unfortunately, now, we need to mitigate and adapt.”
He goes on to explain the practical implications of worsening environmental conditions. Water scarcity and extreme heat in Phoenix, for instance, as well as other cities in the Sun Belt, could drive a sustained reduction in local populations, unsettling real estate markets and reducing the local tax base. “Ten years ago, it was less than $1,000 a month to rent in Phoenix. That number has jumped 2x in a decade. But all of a sudden you may start to see low and medium stock to come under a lot of different public health pressures, a lot of different ventilation pressures, there might not be the willingness on the part of landlords to make the necessary improvements, so you’re either looking at tenants that negotiate discounts or facing lower inbound demand because the place-based features of Phoenix as an overall market become very different. As for the tax base, they are left dealing with greater needs to a smaller population.” It’s a familiar story for several markets that have experienced historic growth. Similarly, popular coastal markets throughout Florida have already experienced much larger losses after natural disasters than historic norms, due to clustering of residential populations and real estate.
A failure to acknowledge such risks can lead investors to make unrealistically rosy underwriting assumptions, culminating in lower than expected NOIs, terminal values, and investment returns. Ranade commented “Unfortunately, there is no line item for climate risk in investment modeling. Re-pricing is a function of different levers being pulled, and more often than not, multiple being pulled in tandem. That impacts, opex, capex, cost and availability of debt, insurance premiums, and taxes. ” Insurance costs, in particular, are a major concern. While underwriting 3% annual growth to expenses is a well-accepted norm, for instance, the firm estimates future insurance costs may grow 7-8% annually in high risk areas, far outpacing rental growth projections in many of the same markets.
Climate Core makes a compelling case for why investors cannot afford to dismiss societal issues like climate risk. Real estate operators have been slow to embrace change in this arena, historically making the case that prioritizing sustainability actually comes at the cost of profitability. By acting as a source of funding for enterprising sponsors that share their thesis, they can both help dispel this perception, while also demonstrating the tangible financial benefits of confronting such risks head on for investors.