Co-Author: Richard West, MAI and EVP of Valuation

Waterfront-Resilient-Buildings

The commercial real estate industry is facing an unprecedented challenge: the ever-increasing threat of climate hazards. From rising sea levels to extreme weather events, these risks are no longer theoretical – they are practical issues with significant financial implications. As data on climate hazards becomes more readily available, property stakeholders have a critical opportunity to take proactive measures to safeguard their investments. This blog aims to shed light on the current landscape of climate risks in commercial real estate and share how the fields of resilience and valuation are collaborating to help investors make informed decisions.

The Current Landscape of Climate Hazards in CRE

Rising Insurance Premiums and Reduced Coverage in High-Risk Areas

One of the most immediate impacts of climate hazards on commercial real estate is the skyrocketing cost of insurance premiums. Insurance is a critical component of risk management for property owners. However, the rising costs and decreasing availability of insurance in high-risk areas are creating significant challenges. As the likelihood of climate-related damages increases, insurers are forced to raise premiums to cover the anticipated costs. This trend is particularly pronounced in regions prone to floods, hurricanes, and wildfires, where insurance rates have risen by upward of 200% for certain hazards. In some markets such as California, Louisiana, and Florida, carriers have even withdrawn coverage altogether, leaving property owners with limited options and increased financial exposure.

This rise in insurance costs directly affects a property’s net operating income (NOI), which is a crucial factor in determining its overall value. Moreover, many lenders mandate specific insurance coverage levels as a condition for financing, further complicating the situation for property owners in high-risk areas. As climate hazards continue to intensify, the availability and affordability of insurance will become an increasingly pressing concern for the industry.

Although insurance costs affect NOI, the future costs of insurance are notoriously difficult to predict. Nevertheless, providing insurers with clarity regarding property characteristics and resilience measures that may be present provides the foundation from which accurate pricing can be obtained. In most circumstances, uncertainty creates risk which results in additional expense, so reducing uncertainty for insurers can help sharpen their pencils on pricing.

Structural Damage, Operational Disruptions, and Devaluation Due to Extreme Weather Events

Beyond the financial burden of higher insurance premiums, climate events can also cause significant physical damage to properties, leading to costly repairs, operational disruptions, and safety hazards. Extreme weather events such as hurricanes, floods, and wildfires can wreak havoc on structures, compromising their functionality and market value.

The impacts of these events are not just limited to the direct costs of repairs. Business interruption resulting from climate hazards can also lead to substantial revenue losses. Recent studies found that businesses in the U.S. experience a staggering $311 billion per year in lost revenue due to extreme heat alone  Additionally, 69% of small businesses impacted by a natural disaster reported being in poor or fair financial condition afterward, underscoring the long-term consequences of such events.

Perhaps the most significant risk posed by climate hazards is the potential devaluation of properties, especially in high-risk areas. As buyers and investors become increasingly aware of the financial implications of climate risks, they may become wary of acquiring properties with significant exposure. This reluctance can lead to lower property values, impacting the exit strategies and investment returns for current owners.

The statistics paint a sobering picture: 15–40% of businesses fail following a natural or man-made disaster, while 94% of small business owners believe a disaster event could seriously disrupt their business within the next two years.  A tenant that is out of business is not likely to pay rent. These figures underscore the urgency of addressing climate risks and incorporating them into property valuations and risk management strategies.

Ignoring these risks could prove detrimental, as properties in high-risk areas may become increasingly difficult to sell or refinance, leading to a potential loss of value and compromised liquidity. Proactive risk assessment and mitigation strategies are essential to maintain property values and ensure a viable exit strategy, regardless of the prevailing climate conditions.

Proactive Measures for Resilience Against Climate Hazards 

Conducting Comprehensive Property Resilience Assessments

Integrating climate risks into due diligence is essential but challenging due to inconsistent data from different providers. Accurate data is crucial for effective risk assessment and management. To assist in selecting the right climate risk modeling vendors, we’ve created a helpful guide with tips for evaluating and choosing providers.

At AEI, we conduct Property Resilience Assessments (PRAs) with meticulous care, collaborating with credible climate data providers. Our PRAs involve comprehensive inspections, stakeholder interviews, and extensive research to develop a holistic understanding of the specific risks each property faces. This approach ensures that you receive accurate and actionable information, enabling you to make informed decisions about your investments.

Furthermore, we incorporate the findings from our PRAs into our Real Estate Valuations, ensuring that climate risk is appropriately factored into the overall property value. This transparent and data-driven approach provides you with the confidence you need to navigate the complexities of climate hazards and make strategic investment decisions.

Developing Tailored Mitigation Strategies

While understanding climate risks is crucial, effective mitigation strategies are the key to preserving and enhancing property values in an unpredictable environment. At AEI, we leverage the insights gained from our PRAs to develop tailored mitigation strategies that address the specific vulnerabilities and potential impacts identified for each property.

Our approach involves identifying practical resilience measures, such as fortifying structures, implementing flood control systems, or enhancing emergency preparedness plans. We also provide detailed cost estimates and highlight potential incentives or financing options, enabling you to make informed decisions about your risk management strategies.

The benefits of proactive mitigation are clear: the National Institute of Business Sciences (NIBS) estimates  indicate that, on average, for every $1 spent on federal mitigation grants, $6 is saved from future losses. By working closely with you to understand your concerns, the property’s intended use, and the specific climate risks you face, we develop customized strategies that optimize resilience and preserve – or even enhance – property values.

Case Study: Enhancing Flood Resilience

One example involved a national portfolio holder of hotels. Among these properties was a historic hotel built in the early 1900s. We helped develop a multi-pronged approach to flood mitigation for this project including:

  • A combination of wet and dry floodproofing:
  • A deployable system requiring training and preparation by on-site personnel.

Each of these approaches is aimed at making the facility more resilient to flood inundation. The goal is to either prevent water from entering critical areas or to allow it in the parts of the structure that are designed to withstand and recover quickly from flooding, using materials that can be easily cleaned and put back into operation. This project is significant not just for its technical aspects, but also because it reflects the client’s commitment to protecting a historic asset.

Frequently Asked Questions: Climate Hazards and Property Value

How are the regulators handling climate risk?

Financial institutions are expected to incorporate climate risk into their overall risk management framework, just as they would with any other material risk. Rich West, MAI and EVP of Valuation, stated that financial regulators view climate risk as financial risk, and therefore should be managed like any other financial risk. Indeed, physical risks can impact value through rising insurance costs and perceptions of value at risk due to damage and downtime, while compliance with energy benchmarking laws can also result in increased costs through required upgrades or fines, thus affecting value. Depending on the desired tenant mix at a property, green attributes can also help retain tenants at higher rates due to the tenants’ receiving the benefit of the green building attributes or resilience measures. How lenders are approaching this varies from simply reviewing potential risk concentrations to deal-by-deal underwriting and working with borrowers on the implementation of corrective actions.

How does climate risk affect value?

Climate risk influences property values through two primary channels: physical and transition risks. Physical risks encompass the tangible impacts of climate-related events, such as hurricanes, floods, wildfires and rising sea levels, which can result in property damage, operational disruptions, and escalating insurance expenses. Transition risks, on the other hand, stem from the global shift towards a low-carbon economy, manifesting in evolving regulations, technological advancements, and changing market preferences.

Climate risk also can drive up insurance premiums, with some insurers withdrawing coverage entirely from high-risk areas, leaving property owners exposed to significant financial risks. Properties with poor energy efficiency or high carbon footprints may face compliance fines or struggle to attract tenants seeking “green” buildings, potentially leading to a “green premium” for sustainable properties.

Importantly, there’s growing evidence that tenants are willing to pay a premium for resilient buildings, which can positively impact property values. Recent data shows tenants (including owner-occupants) enjoy between 31% and 61% of total societal benefits for above-code design. This translates to between $1.19 to $2.71 in tenant benefits per $1.00 of added cost for resilience measures. Furthermore, an emerging trend is reshaping the value equation: the growing tenant preference for resilient buildings. This shift is creating a new dynamic in the commercial real estate market. Tenants are increasingly recognizing the benefits of occupying resilient properties, which include enhanced safety, reduced operational disruptions, lower insurance costs, and improved long-term stability.

This preference is translating into tangible financial incentives. Some tenants are willing to pay premium rents for properties that demonstrate superior resilience to climate risks. This “resilience premium” can offset the costs of implementing climate adaptation measures and potentially increase overall property values.

For instance, in certain markets, building owners who have invested in seismic retrofitting or flood mitigation measures have successfully passed these costs onto tenants through marginally higher rents. The tenants’ willingness to absorb these costs stems from their recognition of the long-term benefits and reduced risks associated with occupying resilient spaces.

Moreover, commercial tenants, particularly in sectors like healthcare, hospitality, and mixed-use developments, are placing a higher value on climate-resilient properties. These tenants often benefit from more favorable financing terms, reduced insurance premiums, and improved business performance in resilient buildings, further driving demand for such properties.

In essence, while climate risks pose significant challenges to property values, they also present opportunities. Properties that proactively invest in resilience and sustainability measures may experience value appreciation due to lower operational costs, reduced risk profiles, and the ability to command premium rents from tenants who prioritize occupying resilient, future-proof buildings. This evolving landscape underscores the importance of incorporating climate risk assessments and mitigation strategies into real estate investment and management decisions.

How can this be evaluated at the deal level?

At AEI, we offer a comprehensive screening tool that enables clients to evaluate climate risk at the deal level. Our tool leverages advanced data analytics and modeling techniques to assess a property’s exposure to various climate hazards, including flooding, hurricanes, wildfires, and sea-level rise. By integrating this analysis into the due diligence process, clients can make informed decisions based on a property’s specific climate risk profile.

Where should we get started?

Integrating climate risk assessment into your real estate strategy requires a systematic approach. Your consultant can help you every step of the way. We recommend beginning with a broad view and gradually refining your focus.

Select Appropriate Climate Data Modeling Providers:

Given the complexity and variability of climate data, choosing the right modeling provider is crucial. We’ve developed a guide to help you navigate this selection process:

  • Evaluate providers based on their data sources, modeling methodologies, and track record
  • Consider the geographic coverage and resolution of their data
  • Assess how well their models align with your specific portfolio needs and risk profile
  • Review the provider’s ability to integrate with your existing systems and processes

Our guide can help you pinpoint which climate data modeling provider works best for your organization’s unique requirements. This step is critical as it forms the foundation for all subsequent climate risk assessments and decision-making processes.

Portfolio-Level Risk Concentration Review:

  • Start by conducting a comprehensive analysis of your entire portfolio to identify risk concentrations:
  • Map your properties against known climate hazard zones (e.g., flood plains, wildfire-prone areas, hurricane paths)
  • Assess the geographic distribution of your assets to identify potential regional vulnerabilities
  • Analyze the property types in your portfolio to understand which may be more susceptible to specific climate risks

Risk Management and Underwriting Policy Review:
Once you have a clear picture of your portfolio’s risk profile and have selected appropriate data providers, review your existing risk management and underwriting policies:

  • Determine how climate risk can be incorporated into your current due diligence processes
  • Identify what additional data or assessments might be needed to properly evaluate climate risk
  • Consider how climate risk factors might influence your investment decisions and valuation models

Develop a Climate Risk Checklist:
Create a standardized checklist to assess climate risks and resilience measures for each property. Start with key items such as:

  • Building certifications related to energy efficiency and sustainability.
  • Presence of energy-efficient features and water conservation measures.
  • On-site renewable energy sources.
  • Resilience features against relevant climate hazards.

Gradually expand your checklist to include more comprehensive items like:

  • Building energy performance and compliance with local regulations
  • Detailed physical risk and resilience considerations
  • Potential costs associated with climate hazards and recommended resilience measures.

Foster Cross-Functional Collaboration:

  • Ensure that climate risk assessment becomes a collaborative effort across your organization:
  • Connect risk management teams with underwriting and asset management teams.
  • Share climate risk data and insights across departments.
  • Incorporate climate risk considerations into regular investment committee discussions.

Leverage Existing Processes:
Rather than creating entirely new systems, look for ways to integrate climate risk assessment into your existing risk management and due diligence processes. As a multi-disciplinary due diligence and risk management firm, we can:

Set Clear Goals and Metrics:
Establish specific objectives for your climate risk management efforts, such as:

  • Reducing the percentage of your portfolio exposed to high-risk climate hazards.
  • Improving the average climate resilience score of your properties.
  • Increasing the number of properties with features that mitigate relevant climate risks.

By starting with this comprehensive, portfolio-level approach and gradually refining your focus, you can effectively integrate climate risk considerations into your real estate strategy. This approach emphasizes the importance of starting somewhere, fostering collaboration across teams, and connecting climate risk assessment to existing risk management and asset value preservation goals.

How are lenders acting on this information?

Lenders are taking varying approaches to addressing climate risk, depending on their specific circumstances and risk appetites. Some lenders are primarily focused on reviewing their portfolios for risk concentrations, identifying properties or regions that may be particularly vulnerable to climate hazards.

Others are taking a more proactive stance, working closely with borrowers to implement corrective actions and mitigation strategies to reduce the potential impact of climate risk. These actions may include fortifying structures, implementing flood control systems, or enhancing emergency preparedness plans.

The level of lender involvement often depends on factors such as the intended hold time of the loan and the borrower’s ability to effectively manage climate risk. Lenders with longer-term exposure may demand more rigorous risk management strategies, while those with shorter hold periods may focus on ensuring adequate insurance coverage and risk pricing.

Final Thoughts On Climate Hazards and Property Value

As climate hazards continue to intensify, proactive risk assessment and adaptation strategies are critical for safeguarding property values – the cornerstone of successful real estate investments. At AEI, we understand that property owners cannot afford to be reactive; they must anticipate and fortify against potential threats to protect their assets and ensure long-term value preservation.

Backed by our extensive expertise and data-driven approach, we empower clients to stay ahead of climate risks through our comprehensive Property Resilience Assessments that seamlessly integrate climate risk analysis into our Real Estate Valuations. Our tailored strategies go beyond merely identifying vulnerabilities; they provide practical, actionable solutions that directly address the unique challenges each property faces.

In this era of unprecedented climate volatility, partnering with AEI can help you navigate and mitigate climate risks effectively. Our unwavering commitment to due diligence and risk management ensures that your investments are fortified against the unpredictable forces of nature, shielding you from the potential devaluation and compromised liquidity that could jeopardize your returns and exit strategies.

Contact us today to schedule a consultation and learn how our comprehensive services can fortify your portfolio, safeguarding your property values and ensuring long-term, sustainable growth.