The Great Repricing: Financial Advice in the Age of Climate ChangeTheGreatRepricing:FinancialAdviceintheAgeofClimateChange

The following article was extracted from The Great Repricing: Financial Advice in the Age of Climate Change, excerpted with kind permission from and presented by Gitterman Asset Management on Entelligent.

In real estate, as in other investment classes, the question is no longer if climate change will affect asset prices, but when and how:  will repricing happen in an orderly fashion or through a series of shocks and sudden drops?  In either case, global asset managers such as PGIM Real Estate are seeking both to mitigate the immediate physical risks posed by current levels of climate change and invest in solutions that move us towards a net zero carbon future. 

The time has come for long-term investors to view climate change not just as a risk factor in their investment framework but as an opportunity for active alpha generation along the path to a greener economy.

At this moment, the most catastrophic physical impacts of climate change are beyond the horizon of most real estate investment decisions.  Even for longer-term investments like residential mortgages, investors seem to look away from climate factors even in geographies most at risk, such as Florida, California, and Maryland¹.

Furthermore, there are some structural factors in the US residential mortgage market that separate long-term risks like climate change from the risks that are factored into the underwriting process. For example, in the secondary mortgage market, banks can offload their conforming mortgage risk to government-sponsored enterprises (GSEs). Since they typically do not retain the 30-year loans they underwrite, banks originating mortgages have little incentive to account for flood risk in mortgage pricing.

But supposing we get past this “tragedy of the horizon²,” the lack of clarity around the timing and geographical manifestations of climate shocks makes it challenging to precisely incorporate them into the pricing of individual real estate assets.  Even though we know that each year brings a more extreme hurricane season, for example, it is hard to predict exactly where and when the next big storm will cause large scale property damage.  And there is always the question of returns that we might miss out on—either by not investing in assets that are highly valued now, even if riskier longer term, or by making larger capital investments now to reduce carbon emissions and mitigate risks that are not reflected in current valuations or income.  While real estate is all about location, location, location, it is also about timing, timing, timing.

However, just because the industry isn’t consistently pricing in climate change, it doesn’t mean that firms like PGIM Real Estate aren’t evaluating it and seeking to be in the best possible position when repricing occurs.  We are increasingly finding that our most sophisticated investors and tenants are demanding it.  Furthermore, we recognize that while a stronger regulatory framework might be hard to adjust to at first, it has the potential to smooth the transition and prevent extreme, unpredictable shocks. 

Incorporating climate change risks and mitigation costs into the heart of the real estate investment process can help manage physical risks and generate additional investment opportunities. First, capital investments to bolster climate resilience can be attractive for equity owners. The adage “an ounce of prevention is worth a pound of cure” certainly applies here. Capital projects will detract from cash flows and operating incomes in the near term and may not be sensible for real estate debt providers; however, direct real estate equity owners are more likely to see the payback when such projects prevent large losses and preserve cash flows later.

Simple renovations like elevating the electricals a foot or two off the ground may make sense for properties in vulnerable areas. In fact, such resilience projects have shown to not only keep the lights on but, more importantly, keep tenants in place during extreme events and maintain steady lease payment cash flows³. Additionally, while assets with a strong resilience strategy don’t currently see any beneficial pricing in the insurance markets, it’s likely this will change in the coming years. This would further decrease operating expenses for asset owners.

Second, by employing cutting-edge data and leveraging their own climate analytics, data-conscious real estate investors can uncover situations where the broader market sees limited value. For example, investors can consider high-risk locations by factoring in resilience-boosting capex into their models for capitalization rates and cash flows.  By integrating these improvements into their investment process, investors can tap into attractive opportunities where markets may overshoot.

Third, with more high-end office and retail space customers demanding certified “green” properties, the additional cost of energy efficient renovations or construction can be offset by attracting and retaining tenants seeking climate-differentiated properties who are  willing to pay a premium for it.

At PGIM Real Estate, we incorporate climate change considerations into each stage of the investment process.  The size and coverage of our global platform gives us an advantage in terms of data availability and efficiency.  One example is our use of the Global Real Estate Sustainability Benchmark (GRESB) rating system.  GRESB is a globally recognized assessment and benchmarking system for Environmental, Social, and Governance factors.  We report over 75% of our AUM to GRESB and use the data generated in building our strategies at the portfolio and the asset levels.  This year, GRESB piloted a resiliency module in beta form.  Although it is not yet incorporated into the GRESB annual scoring system, we utilized it across our GRESB-rated funds and received a perfect score.  As the broader real estate industry adopts standardized resiliency measures, more connections between ESG and valuation will become evident. 

We incorporate climate risk data into our standard due diligence and asset management process. We score each asset for seven climate risks using data from 427.  This information is then incorporated into asset level work plans and budgets for every property, which is an efficient and consistent way to build resiliency.  It informs our ongoing capital and operating standards so that we can create more durable portfolios.  We also make “ESG and R” (Environmental, Social, Governance, and Resiliency) the job of every person in the company, from the CEO down to first year analysts, where Diversity, Equity, and Inclusion (DEI) is an important part of the resiliency equation.  ESG and R goals are a part of the annual goal setting and performance evaluation for each employee.  PGIM Real Estate constantly develops and improves company-wide training as well as ESG and R training by functional area. 

Another factor we consider is that climate change will not affect all populations evenly.  While we often look at climate risk with regards to locations—such as coasts or areas prone to fire—climate change has a disproportionate impact on some people, particularly those in low- and moderate-income communities. Resilient affordable housing is one way to address the disparate impact on both low-income communities and communities of color.  Just as the transition to renewable energy may leave fossil fuel investments stranded, low-income residents may be stranded if their homes are not actively targeted by resiliency strategies. This reinforces the need to build more affordable housing in areas with lower climate risk and target affordable housing and low-income communities in resiliency strategies. PGIM Real Estate’s global investment products, including our US private equity fund, Impact Value Partners, address this need.  Targeted, active strategies like resilient affordable housing, which meet an essential, non-cyclical need, offer investors steady, less correlated returns across the market cycle. 

At PGIM, we believe active investors must be on their front foot, predicting and responding to the impact of climate change on the economies and markets in which investors operate. This will create both immense uncertainty and opportunity. Only forward-looking, long-term investors will have the nimbleness and foresight to seize the opportunities and navigate the risks of our changing climate.

Portions of this article have been excerpted from PGIM’s Megatrend paper Weathering Climate Change: Opportunities and Risks in an Altered Landscape.

¹Kapfidze, Tendayi, “LendingTree Compares Mortgage Rates by State,” LendingTree, February 8, 2019.

²Carney, Mark, “Breaking the tragedy of the horizon – climate change and financial stability,” speech at Lloyd’s of London, London, 29 September 2015.

³PGIM Real Estate.