Can U.S. REITs Take the Heat (Wind and Rain)

Michael Torrance: Welcome to Sustainability Leaders. I'm Michael Torrance, Chief Sustainability Officer with BMO Financial Group. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic, and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment business practices and our world.

Speaker 4: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries.

Camilla Sutton:

How should investors think about rising sea levels, increased frequency of weather disasters and all other climate change related impacts on a real estate holding; climate change in REITs is our focus today. I'm Camilla Sutton, MD and Equity Research at BMO Capital Markets, and I'm joined by my colleagues, Doug Morrow, Director of ESG strategy, and Juan Sanabria, our REITs analyst. It's also noteworthy that John Kim and Ari Klein, two of our other US REITs analysts couldn't join us today. And with that, Doug, welcome back to IN tune podcast, and Juan, welcome to your inaugural one. Let's get started.

Doug Morrow:

Well, thanks very much, Camilla. It was definitely a long-term collaborative process. And I think that really reflects the different types of expertise that were required to put a note like this out the door. So you know, we are obviously proud of the outcome in terms of the analytics. But I would say the teamwork and partnerships also made this note really unique compared to other ones that I've been involved with, certainly. From BMO’s Equity Research team, we had me representing the ESG side of things, and Juan, together with his colleagues, John and Ari, covering off the fundamental equity analyst perspective for US REITs, and we worked closely every step of the way with BMO’s Climate Change Institute, as well as BMO’s data and analytics team. And in addition to that, there was a third-party specialist called Climate Engine that was also centrally involved. So there was a lot of collaboration. And it definitely took some time to plot things out and develop our methodology. And looking back, it actually took over one year from the time of our initial meeting to publication last month, and Juan and I had a lot of deliberation along the way about the best way to package the findings and roll up the analysis.

Juan Sanabria:

As Doug said, it was this one here a really long but rewarding process. We were interested in working on this project because in covering US REITs over the last few years, we've definitely noticed that climate change is becoming a bigger and bigger issue. And for instance, it's being mentioned more frequently on earnings calls, it is leading to more extreme weather events that is in turn contributing to increased insurance costs for the REITs in upwards of 20% in some cases, and investors seem to be generally recognizing that weather patterns are changing. And we're seeing more discussions on the idea that one-time costs should no longer be backed out of earnings in the normalization process. And it's just part of the new normal that companies and investors need to acclimate to.

Camilla Sutton:

It's really interesting how climate change is driving all these new sets of risks and opportunities for investors across multiple industries,part of why I'm so looking forward to our whole discussion today. So, Doug, maybe you can talk about the nuts and bolts of this report and the framework that you used, and then Juan, maybe you can follow in.

Doug Morrow:

Sure. So in terms of the nuts and bolts and what we actually did, just to make it clear for listeners, we as a first step, we collected all of the publicly disclosed property addresses for the 70 US REITs in Juan, John and Ari’s coverage, and this was as of the end of Q1 of this year. So this totaled 39,243 individual properties. So that was really the broad data set that we use to start the project. BMO’s data and analytics team from there, backed up the lat and long coordinates for each of these properties using the Google Cloud geocoding API. And from there, we really relied on the expertise of the BMO Climate Institute and Climate Engine to calculate what you can think of as gross risk scores for flood, wildfire, and wind for specific geographies across the entire continental United States. For flood risk, one of the things that I want to flag one of the things that really makes this study unique is that we used the Fathom US V2 two data set. So this is courtesy of our relationship with Climate Engine. And this is really among the highest resolution flood hazard data sets currently available for the US. For wildfire, the team used a well utilized source called the Historical Burn Index, and then we adjusted it based on fuel load. And for wind risk, we looked at exposure to hurricanes and tornadoes and extracted data from various databases run by the US National Oceanic and Atmospheric Administration or the NOAA. So that's a bit of a summary of the initial steps. Juan do you want to describe the final steps?

Juan Sanabria:

Of course. So basically, up until this point, we have the lats and longs for about 40,000 properties, as well as an understanding of how risky the underlying geographies are in terms of the propensity for both flooding, wildfires, and extreme wind events. The next step was basically just converting all this info into a one to four scoring framework for each property, and for each hazard where a level one risk was low, and a level four risk was high. For example, a level one for flood risk means that a property is exposed to a one in 1000 year flood, or a level four risk means a property is exposed to a one in 20 year flood. Doug and I worked with a team to develop a method to roll all this up into an overall climate risk score for each reading, as well as for each individual REIT sub sector. Doug Morrow: And Camilo, the only thing I'll add there is that those scores and that process that Juan just described, those were basically base case scores because they were based on weather conditions as of today. But to add a little more richness, we also ran two scenarios, where we tested to see what would happen if climate change gets a lot worse. So these were based on the IPCC’s 4.5 and 8.5 scenarios which are really well known in the climate change community. So interestingly, we could do this for flood and wildfire. But as it stands right now, at least, there's no credible model out there for future wind risks. So we were only able to do that for flood and wildfire.

Camilla Sutton:

It's such a fascinating backdrop, and really helps to explain how you set things up. Juan, do you want to tell us a bit about what you found? What are the biggest takeaways from the report?

Juan Sanabria:

Sure, one takeaway was simply the large spread that we found among the REITs in our coverage in terms of how exposed they are to physical climate change risk. And the precision for the modeling, as Doug was talking about earlier meant that different neighborhoods within the same city could have different risk pictures. Southern California being a specific example, companies like Howard Hughes, Equity Lifestyle Properties, and Sun Communities came out as facing relatively high exposure to physical climate risk. This was often due to many coastal assets that they have in their portfolio. However, other companies such as Essex Property Trust, Kilroy, and SL Green scored relatively well, which is to say according to our modeling, they faced relatively low exposure to fiscal climate risks. So certainly the spread and risk values was an interesting byproduct of our research. When we cut the numbers, the sub sectors we found that had the highest risk were manufactured housing, given their focus on the southeast, and the prevalence of wind and flood damage, as was recently witnessed by Hurricane Ian, while office REITs and data centers were at the other end of the spectrum. One of the things that is important to point out as the we've looked at a large, largely a gross risk as opposed to net risk, which means not all buildings are created equal when it comes to climate change adaptation. Some are better prepared than others in dealing with flooding, thanks to proactive management steps on the building that they've purchased or redeveloped over the years and taking account in their age as well. Unfortunately, we were not able to get this level of detail or complexity, it would have significantly expanded the scope of what we're already doing in a pretty big study, I would say. We were upfront about the fact that many the REITs in our coverage universe are highly aware of climate change risk, taking steps to mitigate their exposure through things like water exclusion technologies, fire retardant buildings, etc. So just wanted to set that backdrop for you.

Camilla Sutton:

That's a great way to frame it. So Doug, how about you? What were some of the biggest takeaways from your side?

Doug Morrow:

I think for me, the most interesting thing was the difference that we see between the various flood data sets that are on the market. So for example, many REITs disclose the proportion of their portfolio in 100-year flood zone. This is a commonly used metric. But most or certainly many tend to use flood maps from FEMA. This is the US Federal Emergency Management Agency. And one of the things we learned in doing this report is that the FEMA flood maps, even though they are widely used and accessible, is they're often out of date and incomplete. Whereas we were using a more specialized and comprehensive flood data set, and one that is frequently used by insurance companies. So as just one example Hersha Hospitality Trust recently disclosed that 25% of its portfolio sits in 100-year flood zone. But our analysis put it at 35%. And the issue is just simply one of accuracy of the underlying data set. So how much this information influences an investors decision? I think that's an open question. But in a highly efficient market, I think even a little bit of information advantage can make a big difference. And I think this note definitely gives investors a little bit of an edge.

Camilla Sutton:

So Juan you speak to investors all the time, from a fundamental point of view, how would you say US REIT investors are thinking about climate change risk? Is this something that investors are thinking about? Or is it something they really need to be thinking about a lot more?

Juan Sanabria:

Let's say in the current environment, inflation and higher interest rates are definitely at the core of all of our conversations. However, just this quarter, we've seen the impacts of Hurricane Ian ripple through reported financials. With the constant news flow that the environment is clearly changing, and more rapidly than we'd have expected environmental risks are clearly top of mind. As Doug mentioned at the outset, investors are less willing to back out what management teams have historically categorized as one-time costs or impacts to revenues as a result of climate change. We're also hearing real questions about company's thought processes and strategies about the environmental risks about investing in markets like Miami. From a global perspective, Europe and Canada are more keenly focused on climate change, but we're certainly having increased discussions with US investors who've been hiring experts and conducting their own analysis. One key pain point is that the data that often gets reported is is often not comparable. We think our analysis is unique in that it removes a lot of ambiguity between companies and potential risks while at the same time being upfront about the report’s limitations. So we're hopeful that this helps investors in an increasingly topical focus for them in climate change.

Camilla Sutton:

I'm sure. Well, Doug, what's your view?

Doug Morrow:

Yeah, I would agree with Juan. And I think generally over time, climate change considerations are going to creep more and more into investors fundamental view. We know that weather extremes are becoming more frequent, as Juan said, insurance law, sorry, insured losses from secondary perils are increasing. We know that global sea levels are rising at about three times the historical rate. And in the US billion-dollar weather disasters now happen on average about once every 18 days. And this, this compares to about once every 82 days back in the 1980s. And climate change is a big part of the reason why. So you know, again, as Juan said, there are lots of other things going on in the market today that have really seized investors’ attention, interest rates, inflation, the war in Ukraine, but that doesn't mean that climate change is suddenly going to disappear. So I think that over time, investors are going to want to see that REITs disclose in line with frameworks like the TCFD that they consider climate change in their acquisition processes and due diligence procedures at that they're active with climate adaptation. And I think that this note is going to have a long shelf life for investors looking to understand how climate change could potentially impact their US REIT holdings.

Camilla Sutton:

I absolutely agree. I love where you both took us on this podcast and in the report. Thank you both for joining us today. That was Doug Morrow, Director of ESG and Juan Sanabria, one of our US REITs analyst. BMO Capital Markets is proud to deliver a thoughtful analysis of upcoming Equity Research trends through both this IN tune podcast as well as our commodity specific Metal Matters hosted by Colin Hamilton. If you enjoyed today's in tune podcast, please do subscribe and rate it.

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Michael Torrance: Thanks for listening to Sustainability Leaders. This podcast is presented by BMO Financial Group. To access all the resources we discussed in today's episode and to see our other podcasts, visit us at bmo.com/sustainabilityleaders. You can listen and subscribe free to our show on Apple Podcasts or your favorite podcast provider and we'll greatly appreciate a rating and review and any feedback that you might have. Our show and resources are produced with support from BMO's Marketing team and Puddle Creative. Until next time, I'm Michael Torrance. Have a great week.

Speaker 4: The views expressed here are those of the participants and not those at Bank of Montreal, its affiliates or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy or security. This presentation may contain forward looking statements. Investors are cautioned not the place undue reliance on such statements as actual results could vary. This presentation is for general information purposes only and does not constitute investment, legal or tax advice and is not intended as an endorsement of any specific investment product or service. Individual investors should consult with an investment tax and or legal professional about their personal situation. Past performance is not indicative of future results.