64 | Climate Change and the Role of Active Investors
Location, Location — and Efficiency: Climate Change and Real Estate Valuation
Patrick McElroy, CFA, Portfolio Manager In analyzing climate risk among publicly traded real estate investment trusts (REITs), we consider both physical risk and transition risk as part of our investment process. According to the International Energy Agency, the building and building construction sectors are responsible for over one-third of global final energy consumption and nearly 40% of total direct and indirect CO2 emissions. Owners and developers of buildings will play a key role in the transition to a low-carbon economy. The sector also faces physical risk from climate change, as many real estate companies are facing higher costs, property damage or business interruption from severe weather events such as floods and wildfires. The location and construction quality in a REIT’s property portfolio strongly affect its ability to organically increase rents and grow its revenues, cash flow and dividend. Buildings located in areas prone to extreme weather will struggle to attract tenants, have higher vacancy levels, command lower rents and require higher maintenance capex, all of which results in lower cash flow. Additionally, most REITs are facing an approximate 25% increase in insurance costs as insurance companies have dramatically raised premiums due to losses incurred from severe weather. Climate change also affects a REIT’s cost structure. Higher building material costs and more stringent, climate-friendly building codes have raised costs for new developments. However, REITs can reduce operating expenses and carbon emissions by installing more efficient HVAC systems and LED lighting. More efficient buildings — those that are certified as “green buildings” under programs such as Leadership in Energy and Environmental Design (LEED) — can command higher rents and have higher occupancy rates and lower operating expenses. The World Green Building Council estimates that new green buildings and green retrofits decrease annual operating costs by an average of
