REITs and the recognition of climate change related events as a potential source of systemic risk

Hardly a day goes by without yet another report, editorial commentary or prediction about climate change and its risks, evidenced convincingly by countless scientific studies. Observable, measurable evidence includes increasing ocean and land temperatures; weather patterns and weather-related events of abnormal frequency and intensity such as hurricanes, flooding and wildfires; changing biosphere patterns; accelerating glacial melting at the poles and extreme northern and southern latitudes with consequent rising sea level. For many years, climate change for the finance industry has been understood by market players and regulators as a totally exogenous perturbation that would be nothing more than a bunch of weather perturbations that already occur potentially everyday everywhere, and would eventually, if things go bad in several decades, be addressed through their operational risk framework. This point is crucial, a potential world wide phenomenon has not being recognized as sytemic risk but instead treated as a normal day by day operational risk, without understanding that climate related effects can indeed wipe out or strain the foundations of financial institution operations. Climate fragilities increase financial fragilities. Real estate assets across the nations are susceptible to both gradual and more acute climate risks, depending on geographical location and other factors. The ULI (Urban Land Institute) - Heitman Report published by IRE-BS (International Real Estate Business School) in 2017 and again in 2018, pointedly cited insurance industry volatility (β) stemming from uncertainty about an unknowable future and potentially skyrocketing premiums necessary to cover ever larger losses and claims. Viable and affordable insurance, a key to risk management, depends on being able to recognize and reasonably evaluate future risks. This thesis has as its objective in the study of the relationship between real estate investment funds and site climatic events linked more widely to global climate change. The set objective is to understand whether these funds, in considering the risks in undertaking new investments, or even more simply in the risks of day-by-day operations, consider, in the world general ongoing situation of intensification both in terms of strength and in terms of frequency of severe events, the climatic phenomena as a potential source of systemic risk. To do so, a sample population of 32 different REITs based in three different countries, USA, Japan, Hong Kong, has been analyzed to unveil if really the perception of local extreme climated events linked to the wider global change, are actually matter of concern and taken into consideration as a potential source of a systemic risk for the entire industry and economy. The indicator used to trace the risk is the beta of the company. This coefficient is widely used in financial analysis to depict the systemic risk of security, and we usually refer to it as “volatility”. It compares the measure of the dispersion of returns for a given security or market index and in most of the cases, what it reflects is that the higher the volatility, the riskier the security for a given investor, but generally higher returns. The analysis is carried out researching the selected REITs’ beta trends for the last ten years, considereing all markets in which the funds invest, to then compare them with the other variable, the independent one, of climate events that characterize areas in which funds largely invest. Already in this first phase of the study some interesting elements stood out, pointing out a more aggressive behavior of eastern REITs, that follow a more standard type of investments with less attention to environmental protection, energy efficiency building, but more on the profitability items. While on the western side a more defensive approach by REITs also uncover a more climate oriented behavior, at least for some of them, investing in proper corporate structered plans, also with external actors, to better respond to future needs of the portfolios. The beta coefficient is really important and it is linked to multiple other financial coefficients and measures. Values returned by the systemic risk beta are indeed used in the computation of the cost of equity in the capital asset pricing model, that in turn is also linked to the computation of the cost of capital, important information since it reflects the compensation required by the suppliers of capital to the company. But also, the cost of capital is widely used in the computaton of maybe the most used tool to calculate the viability of investments in the real estate sector, that is the the net present value. The higher the cost of capital the lower the net present value. The analysis then proceeded with a second step, aimed at unveil and investigate whether or not an association between the two variables under analysis is present, making use of a multiple correlation analysis. This analysis, also supported by graphical representation of the variables through proper scatterplots, points out specifically which of the funds take more into consideration climate events as a source of sistemic risk, and also depict to which typology of events a particular fund is more subjected. The results of this second step mainly confirm the previous ones, again pointing out a more widespread association, and thus recognition, of the western REITs compared to eastern ones. The challenge for Real Estate sector in the upcoming years will be to better understand and recognize climate events as a potential source of systemic risk through the proper tools. Some of the sector operators and investors are already doing so exploiting new technologies, construction materials and external professionals expertise to build proper corporate environmental ESG funds. Unfortunately the majority instead still rely on old instruments and don’t even think climate change is a real risk, postponing the issue to future generation of managers. What is sure is that climate risks affect not just the sustainability and physical resilience of properties, but also as their value (at present and in the future), capital appreciation, revenue and liquidity. Common “Tools” used by the majority of real estate companies, like Sustainability Due Diligence and KPIs are nowaday sufficiently spread, but surely they are not up to the situation. Strategic planning approaches like scenario analysis are almost totally lacking. This is due to the lack of awareness of long-term consequences, including the functional chain. Traditional tools and models rely strongly on the derived implications based on historical quantitative analysis, and so does also the real estate and construction sector, generally reluctant to big changes. In contrast of course, most of the risk related to climate change related extreme events involves forward looking data and studies which are often only available in a more qualitative form. To obtain a clear view on possible outcomes of future performance, the uncertainty and fundamental shifts of the real estate industry must be captured with appropriate tools.

Non passa giorno senza l'ennesimo rapporto, commento editoriale o previsione sul cambiamento climatico e sui suoi rischi, evidenziato in modo convincente da innumerevoli studi scientifici. Le prove osservabili e misurabili includono l'aumento delle temperature oceaniche e terrestri; modelli meteorologici ed eventi meteorologici di frequenza e intensità anormali come uragani, inondazioni e incendi; cambiare i modelli della biosfera; l'accelerazione dello scioglimento glaciale ai poli e alle estreme latitudini settentrionali e meridionali con conseguente innalzamento del livello del mare. Per molti anni, il cambiamento climatico per il settore finanziario è stato interpretato dagli attori del mercato e dalle autorità di regolamentazione come una perturbazione totalmente esogena che non sarebbe altro che un mucchio di perturbazioni meteorologiche che si verificano già potenzialmente ogni giorno ovunque e che alla fine, se le cose andassero male in diversi decenni, essere affrontati attraverso il loro quadro di rischio operativo. Questo punto è cruciale, un potenziale fenomeno mondiale non è stato riconosciuto come rischio sistemico ma trattato come un normale rischio operativo quotidiano, senza comprendere che gli effetti legati al clima possono effettivamente cancellare o mettere a dura prova le basi delle operazioni degli istituti finanziari. Le fragilità climatiche aumentano le fragilità finanziarie. Gli asset immobiliari in tutte le nazioni sono suscettibili a rischi climatici sia graduali che più acuti, a seconda della posizione geografica e di altri fattori. L'ULI (Urban Land Institute) -Heitman Report pubblicato da IRE-BS (International Real Estate Business School) nel 2017 e di nuovo nel 2018, ha citato in modo acuto la volatilità del settore assicurativo (β) derivante dall'incertezza su un futuro inconoscibile e premi potenzialmente alle stelle necessari per coprire perdite e sinistri sempre più grandi. Un'assicurazione redditizia e conveniente, una chiave per la gestione del rischio, dipende dalla capacità di riconoscere e valutare ragionevolmente i rischi futuri. Questa tesi si concentra nel capire se in un campione di popolazione di 32 diversi REIT con sede in tre diversi paesi, USA, Giappone, Hong Kong, la percezione di eventi climatici estremi locali legati al più ampio cambiamento globale, siano effettivamente motivo di preoccupazione e presi in considerazione. considerazione come potenziale fonte di rischio sistemico per l'intero settore e l'economia. L'analisi viene svolta ricercando i trend beta dei REIT selezionati negli ultimi dieci anni, considerando tutti i mercati in cui investono i fondi, per poi confrontarli con gli andamenti degli eventi climatici dell'area attraverso un'analisi di correlazione multipla. I valori restituiti dal coefficiente di rischio sistemico beta nel calcolo del costo del capitale nel modello di capital asset pricing, sono anche collegati a molteplici set di strumenti utilizzati dal settore immobiliare per valutare la fattibilità degli investimenti come il calcolo del costo del capitale e a sua volta dei valori attuali netti. La sfida per il settore immobiliare nei prossimi anni sarà quella di comprendere e riconoscere meglio gli eventi climatici come potenziale fonte di rischio sistemico attraverso gli strumenti adeguati. Alcuni operatori e investitori del settore lo stanno già facendo sfruttando nuove tecnologie, materiali da costruzione e competenze di professionisti esterni per costruire adeguati fondi ESG ambientali aziendali. Purtroppo la maggioranza invece si affida ancora a vecchi strumenti e non pensa nemmeno che il cambiamento climatico sia un rischio reale, rimandando la questione alla futura generazione di manager. Quello che è certo è che i rischi climatici influenzano non solo la sostenibilità e la resilienza fisica degli immobili, ma anche il loro valore (presente e futuro), l'apprezzamento del capitale, i ricavi e la liquidità.