Weathering the Storm: Real Estate Strategies for a Climate-Resilient Future

Extreme weather conditions are difficult to ignore these days. Recent events like deadly flooding in Brazil or heavy rains in Rwanda give us a scope of the climatic brutality that seems to be going on in the world.

Looking at it from a more structural perspective, extreme weather also heavily damages real estate and is becoming as tangible and impactful as climate change itself. Still, since real estate is the biggest asset class globally, development must continue regardless of climatic hardship. New deals taking place in this era of environmental risk sensitivity involve purchasers aware of climatic concerns. They have walked away from agreements and even got massive concessions from sellers by negotiating climate risk on the property. Real estate investors and homeowners who deny or gaslight climate hazards are less likely to close deals in a potentially bullish housing market outlook for 2024.

Worryingly, there is practically no conceptual limit to how climate could adversely impact real estate and vice versa. Even tools such as FEMA flood maps or wildfire maps for fires are not suited for the task since they reflect historical experience rather than the real picture of an accelerating climate change.

In reality, no certified standard protocols have been created to evaluate these risks appropriately. As for the damage that buildings can cause, the standard property diligence activities, which include environmental site assessment for contamination (ESA) on commercial real estate and residential property, do not address climate risk. This contamination from construction aggravates climate change.

In this article, we will address the main dangers currently impacting real estate, what owners and developers can do to mitigate future extreme weather conditions, and how construction can shift and optimize toward decarbonization.

Transition Risks on the Horizon for Real Estate

As we become somewhat desensitized to extreme weather, real estate assets face another major challenge: the so-called ‘transitional’ risks. Transitional risks are related to societal reactions to climate change, which drive more sustainability in construction. These risks create the cost of complying with climate-focused regulation on real estate developments, adapting to new consumer perceptions and market behavior, and financing new structures with more resilient designs. They also might require adaptive retrofits to buildings.

New climate-focused regulation stretches to the cost of indirect emissions, making it a non-trivial operational issue to consider in the coming decades. Real estate will be impacted by increasing regulation over building standards, a goal linked to carbon pricing to increase decarbonization. Construction, refurbishments, and demolition contribute significantly to generating indirect emissions and will likely be monitored more closely. In addition, construction costs are expected to rise as the prices of carbon-intensive building materials increase due to stricter environmental regulations.

Given shifting market preferences and growing climate change awareness, it is no surprise that potential buyers and developers opt for smarter, high-efficiency buildings with renewable energy sources. These buildings offer emission reductions, which may be a savvy play in anticipation of increasing regulation.

Also, regulations on contamination have made environmental diligence quickly go from nonexistent to routine. Before 1980, with very few exceptions, no laws demanded strict remedial liability on owners or operators of a contaminated building. After the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) or ‘Superfund’ in 1980, lenders and purchasers made environmental evaluations a standard part of pre-acquisition diligence. This act uncovered problems and associated liabilities that were previously unthought of.

Unmasking Climate's Impact: Real Estate's Looming Risks

Aside from the less tangible societal transitional risks, the genuine concern in terms of damage lies in climate´s potential physical manifestations. These so-called ‘physical’ risks are potential dangers caused by a changing environment that has tended towards extremity since the early 21st century.

Evidence shows that extreme heatwaves, among other physical hazards, have increased since the 1950s, and human-induced climate change is the main driver. When global warming increases, these extreme conditions also increase. The heavier risks include sea level rise, coastal flooding, inland flooding, wildfires, drought, extreme storms and wind, subsidence, heat waves, heavy precipitation, and cold waves.

In real estate, physical and transitional risks affect almost every aspect of a building's operations and value. Physical risk can be mitigated through basic infrastructure and design adaptations. Reinforcing structures and using stronger and fire-resistant materials can prove useful in wildfires and hurricanes. In flood-prone areas, consider elevating structures above predicted flood levels and implementing drainage systems.

However, despite improved infrastructure, expensive or difficult-to-obtain insurance coverage will become more common. Thanks to more frequent extreme weather conditions, insurance premiums over real estate have risen, and it has become harder to insure properties in some climatically more aggressive regions.

Since 2017, insurance rates over commercial real estate have risen an average of over 7%, according to an August Moody’s report. This increase marks a significant jump from the typical annual growth of roughly three percent. Many insurers have even pulled out of high-risk markets like Florida and California due to the increasing regularity of extreme weather conditions after being scared off and priced out.

Given all this uncertainty, it helps to look further when considering acquiring real estate. According to Savill's Climate Resilient Cities Index, the safest cities to purchase real estate are Berling, Toronto, Paris, and Madrid, with real estate markets having some of the lowest risk exposure to climate change globally. Savills' research highlights that even in cities with solid real estate resilience, much work must be done to reduce carbon emissions and upgrade assets to higher sustainability standards. On this quest, New York and Berlin are at the top of the list, with 1.8% and 1.5% of ‘green’ real estate stock per capita, respectively. Still, it comes as a low proportion given the urgency of delaying climate change and that investors are actively searching for the most sustainable real estate stock and avoiding owning stranded assets.

Recommendations for Real Estate Risk Management

The lack of prescriptive approaches for risk mitigation in real estate creates an opportunity for investors to get ahead before climate diligence habits become more widely adopted and standardized. The key is hiring experts who can tailor their analysis to the nature of the asset and geography and ultimately give advice over deals that go down between parties.

We suggest taking a holistic approach in future real estate deals. Aside from studying how up-to-par the building is to long-term sustainability standards, consider the bigger picture, such as its geographic landscape and neighboring area. Gathering all this data will help you analyze and approximate both the sustainable side of a building and the potential risk that the construction might face during extreme weather events.

Consider the following steps:

1) Get Familiar With the Energy Demands of Real Estate Assets

The energy use and emissions footprint a building generates provide a useful picture of the future transition risk it can face. The 2022 energy crisis has shown that volatility in energy markets can influence economic and property market outlook, especially ‘energy-hungry’ property types. One significant cause for volatility in the energy markets was the resurgence of global economic activity following the COVID-19 pandemic, leading to a surge in energy demand. This increased demand coincided with supply chain disruptions, particularly in the natural gas market, exacerbated by geopolitical tensions and extreme weather events. Due to potential looming weather events, a volatile energy system is a distinct possibility, leading to unreliability in the energy supply and negatively impacting an asset's operations.

Also, government policies regarding stricter efficiency standards or even taxes on carbon emissions can impact the bottom line of real estate assets, leaving the most carbon-intensive buildings facing structural disadvantage. In specific regions, retrofits may be costly, but they are necessary to bring inefficient buildings up to standard before they are sold or leased. These sustainability challenges make it critical for investors, property managers, and developers to procure a baseline estimate of an asset´s energy use and emissions profile. This data is helpful to compare and rank assets amongst each other regarding contamination levels and will reveal the ones most exposed to transition risks. Detailed knowledge of energy use and emissions can also clarify the required capital for potential retrofits or new builds.

Improved building insulation, heat pump installation, smart controls for lighting, and other building operations are recommended steps for feasible energy efficiency measures. On-site generation, commonly used in installing rooftop solar arrays, can enable a property to sell energy back to the grid and hedge against potential energy market volatility. Efficiency upgrades and on-site generation will reduce energy costs and bring the asset closer to a higher level of sustainability and decarbonization.

2) Apply Environmental Stewardship and Nature-Based Solutions

Conscious environmental and social practices are essential across all economic sectors. Real estate, in general, and new construction, specifically, can impact local environments, ecosystems, and community livelihoods. The more relevant concerns should include disposing of waste from operating buildings and successfully encroaching built environments into existing natural ecosystems.

Asset owners should strive for and promote zero-waste solutions that prevent waste from polluting neighboring natural areas. Nature-based solutions should be the primary objective. Examples of these could be wetlands, which protect against flooding, or even simpler tactics like tree cover, which generates shade and lowers heating and cooling costs. New construction must consider ways of creating buildings that coexist and function in concert with previously existing ecosystems.

3) Consider Advanced Tech and Expertise in Environmental Due Diligence

The most recent environmental diligence practices in real estate focus on leveraging technology, data analytics, and sustainability frameworks. Among other early movers, consulting firms such as Moody's and S&P Global have developed tools to map forward-looking physical climate risk. These products often rely on artificial intelligence to analyze large data sets, recognize physical and transitional risk factors, and analyze at a micro-scale of a single asset or a 10-square-meter location.

We also recommend considering adding climate expertise to internal underwriting teams when closing a deal in real estate. Engage with local environmental or civil consulting firms that possess the technical depth to understand and interpret data models run by others. Also, get familiar with local regulatory trends and with jurisdictions that already have or might plan to adopt carbon-reduction codes as a preventive measure.

Still, it still needs to be made clear which of the available tools in the market truly deliver meaningful and actionable data. Also, according to a report from ESG data, there is an increasingly politicized concern over unreliable or intentionally deceptive measures to gauge sustainability and misleading environmental claims, often called ‘greenwashing.’ We suggest maintaining a similar healthy skepticism over the effectiveness of non-proven, forward-looking climate-measuring tools.

Final Thoughts

Climate change and extreme weather impacting homeowners and real estate investors have resulted in historical billionaire monetary losses up to this day. Climate diligence for physical and transitional risks in real estate, especially before greenlighting new building constructions, should be a routine practice. It will ultimately bring better structuring of deals and provide more information between counterparts, even if it results in pickier, more complex negotiations due to higher risk being uncovered. It will also raise owners' awareness of minimizing the overall risk of a property by applying more resilient construction and maintenance practices.

Assets purchased in 2024 will be priced into a market far more conversant and sensitized to climate risk. Those who integrate climate considerations into their assets as standard diligence now (and not in 2025) will see profitable returns on a relatively minor investment for the coming decades.