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Will Climate Change Concerns Impact Real Estate Investment Strategies?

Phoenix’s real estate market has been hot for quite some time, like much of the Sun Belt. According to Colliers, office, retail, and industrial investment sales in Phoenix through June 2022 totaled $4 billion. In 2021, Phoenix experienced record-breaking commercial real estate sales, and local, national, and international investors continued to show interest in the city. Colliers reports that Phoenix posts top-tier jobs, strong home sales, rising land prices, and stable rental rates. “New investors are visiting Phoenix every week looking for ways to invest,” the brokerage firm said in a recent report.

Phoenix is America’s 5th most populous city and a hot market, but it’s getting hotter in another way, too. Phoenix and Tucson, Arizona, are two of the fastest-warming cities in the U.S. over the past decade, according to one report. Arizona has seen an increase in average summer temperatures of 1.8 degrees since the 1970s, and the state has also seen a rise in ‘danger days’ when the combination of heat and humidity makes it dangerous to be outside for even short periods. Phoenix is projected to see 146 dangerous days annually by 2050. Tucson now already has 24 more days above 100 degrees Fahrenheit on average per year than in the 1970s, which is the second-largest increase of any American city. The punishing heat in Phoenix and parts of Arizona could also lead to more drought and make life there miserable in the decades ahead.

In 2020, almost 200 people died from extreme heat in Phoenix. It was the city’s hottest and deadliest summer on record, as 53 days topped 100 degrees Fahrenheit. “2020 was a glimpse into the future – it’s the type of summer that could be normal by 2050 or 2080, so that’s what we need to be prepared for so that Phoenix is livable and thriving,” said David Hondula, the director of Phoenix’s heat response and mitigation office.

Many cities like Phoenix in the U.S. are increasingly thinking about climate change impacts like extreme heat. But the question is, when will these impacts start affecting real estate investments? And have they started impacting investments already? The answer is mixed. In general, real estate investments have a 10-year horizon, so it may not make the most sense for investors to be so worried about a looming climate crisis in places like Phoenix, at least for right now. But some pundits say that by 2030, harsher impacts will be felt, leading to a potential value decline. And unless investors are explicitly flipping properties in a short time, the effects of extreme heat and drought in a city like Phoenix would have to be considered.

Burning like a Phoenix

Phoenix is just one case study. Florida and coastal areas in the Northeast, Mid-Atlantic, and Southeast may already be experiencing real estate value changes because of climate change-induced sea level rise. According to a report from a climate change research organization called First Street Foundation, home values in New York, New Jersey, and Connecticut fell by $6.7 billion between 2005 and 2017 because of flooding related to sea level rise. Most recently, Kentucky and Missouri have both suffered from extensive damage and even deaths as a result of riverine flooding – far from the sea.

With Phoenix and Arizona, the concern is the more extreme heat and drought that could possibly lead to outward climate migration. For decades, people have moved from cold climes to Arizona because of the weather; but if extreme heat accelerates, this may reverse, and people could trickle away.

Building owners and government officials in Phoenix are already doing all they can to mitigate the impacts. Many buildings in Phoenix now have a cool, white roof that doesn’t absorb the heat as much, and more buildings are electrifying heating and cooling systems to reduce fossil-fuel use. Many glass-facade offices in Phoenix use external shading systems that sit like a skin on the outside of the building, reducing overheating problems and peak cooling loads. Some Arizona building owners also start cooling in the early morning on the year’s hottest days to ensure the building is super-cooled during peak heat times.

Urbanization and the buildup of concrete infrastructures is one reason Phoenix and many American cities are hotter than outlying areas. The phenomenon is known as the urban heat island effect, something that’s been well-documented for years. Phoenix officials believe that cooling technologies and solutions, some high-tech and some not, such as planting more trees and setting up cooling canopies, can make the city more livable. But, given how hot it already is and could be soon, that remains to be seen. Despite the extremes, Arizona can have a pleasant climate during many parts of the year, much like Florida. But extreme changes in the climate may create a breaking point. “I don’t expect a switch will be flipped, and there’ll be a giant instant exodus from places like Phoenix that keep getting hotter,” said John Macomber, Senior Lecturer at Harvard Business School. “I think the exodus will be slower and more gradual.” Heat is a slow-moving and gradual impairment of property values; it’s a different phenomenon than intermittent disasters like wildfire or storm surges.

Macomber emphasized that those with access to capital and information in Phoenix will be okay, and conversely, the poorer residents – with poorer access to information and less household wealth — will suffer the impacts the most. This is especially true of the Phoenix homeless population. He also said that he thinks real estate values in Phoenix and Arizona will decline (or grow at a much slower rate) over the next decade because there will be less reduced market demand as interest rates rise and COVID-19 concerns abate. But, for the time being, the real estate markets in Arizona and Florida are strong and robust. So, the question is how harmful will the climate impacts be, how soon they will hit, and will they be more of a consideration than all the other factors that go into home purchases or commercial site selection.

According to Macomber, many real estate investors flocking to Phoenix may not
be thinking of climate risk exposures as a top-level concern within their investment time horizon and financial return requirements because of shorter-term thinking, but that prioritization changes with organizations and investors with longer investment horizons and access to cheaper capital. Hospitals and universities are examples of organizations and entities that are thinking about how to incorporate climate issues in their facilities planning, whether around heating and cooling or wildfire and flood. They have both a longer hold period and a lower discount rate than commercial investors, and this justifies much more consideration of long-term possible impairments. For example, “Arizona State University is thinking about heat and climate impacts for sure with all their buildings,” Macomber told me.

Short-term thinking

Commercial property databases and research providers are also increasingly considering climate change risks. For example, Moody’s REIS has added climate risk scores on its analytics platform. The property database ATTOM has even started including climate change information in its ratings at the property level for five hazards: wildfire, flood, heat, storm, and drought. ATTOM assesses properties with a 0-100 rating for five climate hazards with projections going as far out as 2050, and the risk data is updated quarterly. “Understanding current and future climate change risk have become a critical data point for many of our customers in real estate, mortgage, and insurance industries,” said Sean Mooney, vice president of product at ATTOM.

But is anyone in commercial real estate using the data? So far, it appears there hasn’t been a big appetite for it. Moody’s research says many developers in Miami, a city with potential climate change risk, haven’t integrated the climate risk analysis into property assessments yet. The Miami metro saw the highest percentage of assets exposed to flooding between 2015 and 2019, but it added the most volume of new space to its inventory during this time.

Macomber pointed out that new buildings in Florida can consider investing in resilience. For example, higher elevation first floors, more wind protection, more robust emergency power solutions, and keeping all of the mechanical equipment out of below-grade spaces. These kinds of new projects attract tenants since they anticipate property level perils. Less resilient offices, homes, and condominiums are less appealing.

Reports from organizations like the Urban Land Institute (ULI) are urging real estate investors to start thinking further about the future of climate change. A recent report from ULI and Heitman, a real estate management firm, said climate change could trigger a substantial shift in real estate demand. The report recommends that real estate investors build their capacity to assess and manage market-level investment risks and understand key markets’ climate change adaptation needs. “The real estate sector is reaching a crucial stage in the evolution of its approach to climate risk,” said ULI’s global CEO, Ed Walter.

The alarmist warnings have not yet changed the real estate market. Phoenix and other places with supposed climate risks are hot in the short term, and thinking too far into the future doesn’t make much sense to many. Real estate investors also have to factor in federal, state, and local climate regulations like those that seek to decarbonize the building sector. But the politics of climate change are messy, and developing and implementing regulations is slow-moving in most cases.

Macomber of Harvard doesn’t expect many governments in the U.S. to get organized to do much concerning climate change perils. “Much of this will be driven by insurance and mortgage companies,” Macomber said. “But even those entities are both all operating with different information. Who is working with which climate models? Historically, banks and insurance companies have relied on historical data, but that’s less useful today. Whose proprietary climate projection should be used now? They’re starting to put risk numbers on real estate assets, which lowers values, and pretty much everyone in the industry wants to see higher values posted.”

Insured losses from natural disasters like wildfires and hurricanes have spiked 250 percent in the last 30 years, according to a report by consultants Capgemini and financial industry body EFMA. This increased severity and frequency of climate-related threats has caused insurance firms to rethink their approach to underwriting coverage, resulting in decreased affordability and availability in disaster-prone areas. 

If developers and property owners can’t procure flood or fire insurance at all, then they won’t be able to borrow money from traditional sources. This would be a major problem. State and federal insurance programs do exist, but their business models involve deep subsidies from other taxpayers, and this may not continue. From a loss point of view, if property owners have to go uninsured (e.g., self-insured) or hope that FEMA or another agency will rebuild their properties after the fact, they are highly unlikely to recover all of their economic losses.

Movin’ out

Real estate investors seek markets and metro areas with growing populations and vibrant economies, which is something else that climate change could impact. There are multiple reports of climate migration away from perils in the U.S. already happening, and it is expected to worsen over time. People must move temporarily or permanently when homes and businesses get destroyed by wildfire, hurricanes, or other disasters.

In 2020, weather-related disasters worldwide displaced 30 million people, and wildfires uprooted more than a million Americans, according to the Internal Displacement Monitoring Centre. A prominent example of climate migration can be found in Louisiana and New Orleans. At least 70 percent of New Orleans’ population fled the city immediately before and after Hurricane Katrina, and some residents haven’t returned. 

New Orleans has been painstakingly rebuilt since Katrina, but today the city still has about 60,000 fewer residents than before the mega-storm. Louisiana could be the first U.S. state to see large-scale climate migration, not as a massive exodus all at once, but from families and people making choices in the years ahead to move to higher ground.

The same could be true of Phoenix and other cities in Arizona as temperatures continue to climb and reduce the quality of life. As demand for real estate declines, so do property values, and a once red-hot real estate market cools down. Many real estate investors may not be thinking this far into the future, simply seeking to cash in on places like Phoenix and other hot markets that offer good returns in the short term. But as the so-called climate crisis heats up, insurance gets more expensive, property management costs and damages climb, things may change.

Only a handful of real estate investors are factoring in climate risks now, using data from property research firms and climate models, but it could be a sign of things to come. Buildings can only crank up the AC for so long and we can continue to rebuild after disasters but eventually there will be a breaking point. So far, extreme heat doesn’t seem to be factoring into real estate investment decisions, but a growing number of stakeholders are betting it will begin to reshape markets in the near future.

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