Climate Change Risk and Real Estate

whirlpool waterInvestors trust that carefully selected real estate will generate stable cash flow in the face of market volatility. However, climate change and extreme weather events like flooding, wildfires, wind and ice storms, can damage or completely destroy real estate assets. Considering Canadian pension funds and banks make significant investments in real estate, it’s in their best interest to examine climate risk exposure across their real estate portfolios. High-level analysis suggests the financial value at risk is material, and well worth the effort.

The top 10 Canadian pension funds manage over $150 billion in real estate investments, which comprises 10 to 17 percent of the total assets under management. Their real estate investment mix is typically made up of office, retail, multi-residential, industrial and hotel properties located around the world. Unlike pension funds, the big banks in Canada are large residential lenders. Canada’s five largest banks hold over $701 billion of residential mortgages in the country. On average, 40 percent of these mortgages are uninsured.

Considering flood risks alone—from the spectrum of possible climate risks—the financial implications to real estate investors are concerning. To illustrate, let’s consider the July 2013 floods in the Greater Toronto Area (GTA). The property and casualty insurance industry estimated that the average commercial property claim was close to $70,000, with larger commercial properties average claims exceeding $1 million. Residential properties average claims were close to $30,000.

The scientific community has confirmed that the frequency and severity of extreme weather events is expected to increase. It is therefore reasonable for the insurance industry to increases prices for riskier assets, and withdraw insurance completely in the most flood-prone areas.

Pension funds should ask: How many of the large commercial properties that they own are located in flood-prone areas? Is it reasonable to expect that insurance will continue to cover $1 million losses at an affordable premium? If insurance becomes unavailable for these large properties, who will take on the risk of ownership? Or should the investment be disposed of?

Some property owners have been proactive in responding to these questions. For example, after the 2013 floods in Alberta, OMERS-owned Oxford Properties moved major systems, such as backup generators, to higher floors and altered its water-pump systems in select Calgary towers. Following Hurricane Sandy, JLL research found that 85 percent of landlords in New York City made their office buildings more storm proof, and 70 percent moved switching gear to higher levels.

Impact on banks

For banks, flood-induced mortgage default risk may be brewing, as Canadian municipalities have suffered from repeated floods over the past decade. Accordingly, many homeowners incurred debt in order to pay for flooded basements and property damages. Those who had insurance that covered damages fared better than those who did not. However, insurance typically covers only a third of total costs of property damages, so all homeowners likely felt a financial impact.

One can expect that right now there are many homeowners in Canada who have limited or no flood insurance and who have accumulated debt due to flooding and who are still located in flood-prone areas. With $30,000 as the average cost to fix a flooded basement according to statistics from July 2013, chances of mortgage arrears or credit defaults following yet another large flood are high among these homeowners. Burdened with debt and without insurance to cover their damages, these homeowners may not be able to pay to fix a flooded basement. Cash illiquidity was noted in Ipsos Reid research, which found that nearly 50 percent of Canadians are within $200 of not being unable to pay for their monthly bills. In the case of sanitary sewer back-up, basement cleanup has to occur within days — otherwise, homes become uninhabitable. This exacerbates the problem for banks, as uninhabitable homes hold little value.

The magnitude of flood-induced mortgage default risk is hard to predict. The Insurance Bureau of Canada estimates that 20 percent of Canadian households are at high risk of flooding and 10 percent are at very high risk. If just half of the very high risk households experienced repeated flooding previously and now have limited or no insurance protecting them, then five percent of residential properties may be at risk of mortgage defaults should their basements flood again. In this case, household savings will likely be insufficient to cover clean-up costs, resulting in potential mortgage defaults of $35 billion between Canada’s five biggest banks.

A large number of unknowns combined with limited disclosure make it difficult to fully grasp the magnitude of real estate climate risk exposure across Canadian pension funds and banks. However, floods alone seem to pose material threats to the stability of returns from real estate investments. The time is now for pension funds to revisit risk assessment models and influence their asset managers to conduct climate risk assessments, mitigation and adaptation activities. At the same time, Banks also need to examine climate risk and ensure it is integrated into their risk assessment processes. As primary providers of property financing, banks are uniquely positioned to influence homeowners’ actions to address these climate-related risks.

Natalia Moudrak is Director, Natural Infrastructure Adaptation Program, Intact Centre on Climate Adaptation Faculty of Environment, University of Waterloo