How Climate Change Could Affect CRE Valuations

Climate change poses a unique threat to the value of commercial real estate.

MSCI, the financial services company formerly known as Morgan Stanley Capital Investment, used its own model to assess that risk.

“Many assets investors own can only figuratively be underwater when a company becomes insolvent or a stock loses all its value. But for real estate, with long-life fixed assets, there is — literally — a real possibility a building might one day be underwater because of climate change,” MSCI Research Executive Director Bryan Reid said in a blog report. “Given this, investors in real estate may benefit from a better understanding of potential physical and transition risks.”

Reid used the MSCI Real Estate Climate Value-at-Risk (Climate VaR) model to demonstrate how the nature and magnitude of physical risks may differ across assets and portfolios and to highlight the importance of considering transition risk as regulatory requirements increase.

With a sample of 671 assets from the MSCI US Annual Property Index, the firm assessed two critical physical risks: coastal flooding and tropical storms. The areas of focus were New York City, North New Jersey, Long Island metropolitan area and the Miami-Fort Lauderdale-Pompano Beach (South Florida) metropolitan area.

“The results suggested that, for this sample of institutionally owned assets, the total Climate VaR due to coastal flooding was lower than for tropical storms in both regions,” Reid said. “However, there was some difference in the relative size of these two types of physical risks. In this sample, the Climate VaR from coastal flooding was lower in South Florida than in NY, NNJ, LI (-0.7% vs. -1.3%), but the Climate VaR from tropical storm exposure was higher (-5.3% vs. -4.0%).”

Reid observed that for coastal flooding, only a handful of assets with the highest exposure were responsible for nearly all (91%) of the estimated risk. Tropical storm exposure was more evenly distributed across the sample, he said.

But physical risk is only part of the picture. “While there may be a temptation to focus on physical risks for real assets, transition risk may play an increasingly important role as well,” Reid said. “As the world moves towards a low-carbon economy, there are several potential emissions pathways available, with the required emissions reduction for each pathway being inversely proportional to the amount of warming. For example, limiting warming to 1.5 degrees Celsius would require more drastic cuts than a 2 degrees Celsius scenario which would in turn require more cuts than a 3 degrees Celsius scenario.”