The world’s climate is changing, manifesting in extreme weather events. In Florida, for example, where hurricanes have been a seasonal fact of life for as long as records exist, the severity of the rainfall levels and floods that accompany those hurricanes has markedly increased in recent years.
The impact on credit markets of such environmental developments can be difficult to quantify, especially in the private markets – but it is very real.
Federated Hermes published the results of research into the pricing of ESG in the public credit markets in 2017, updating the research over time. The result was an ESG risk curve derived from the relationship between ESG risks and credit spreads, drawing on environmental data from sources including the Carbon Disclosure Project and Trucost.
The data displayed opportunities for profit and better risk management given, as Hermes put it in its 2018 report, “improving ESG behaviours that are not reflected in tighter credit spreads” on the one hand, and deteriorating ESG practices, also not yet reflected in the spreads, on the other.
That process is most straightforward for public markets and sovereign issuers. The availability of credit default swap spreads for private entities, on the other hand, is limited. It’s intuitive that if floods have become more likely than they previously were in a given area, then the creditworthiness of loans backed by real estate has taken a hit.
Vincent Nobel, head of asset-based lending at Federated Hermes, says using ESG data as a risk tool has been very helpful. He says his private debt-oriented group has entered into only two office-property transactions during the past five to six years, largely the environmental issues that served as a red flag. “Given the underperformance of office property over those years,” he adds, “this has been the right call.”
Nobel says that as asset management is a demand-driven industry, “the ultimate investor has to see the benefit in ESG calculations. In Europe, there is definitely a strong demand for that, marking a divergence from some parts of the US market, where the term ‘ESG’ has, unfortunately, become politicised”.
Under the radar in US markets
In the US, regardless of politics, there is a broad though not universal recognition within the investment community that recent years have brought a spate of value-destroying environmental events and that it is not a large leap of logic to connect these events to the rising temperatures of the Earth’s oceans.
Shawn Quinn, managing director of Santa Monica, California-based Wilshire, which underwrites alternative funds, says threats from potential environmental disasters have not been internalised into prices and expected returns.
Speaking of the US markets, with specific reference to extreme weather events in Florida and California, Quinn said that those impacts have been, in effect, drowned out. “There are a number of more traditional factors such as corporate headwinds and rising interest rates that are impacting valuations to a greater extent, so while environmental factors could impact valuations, the broader macro setting is more impactful today.”
Gunnar Branson, chief executive and president of the Association of Foreign Investors in Real Estate, tells PDI that a 2022 “survey showed that 85 percent of the members of AFIRE believe that climate change is not currently priced into the pro formas – that is, the expected income and expenses of properties and projects”.
“While environmental factors could impact valuations, the broader macro setting is more impactful today”
On the other hand, it certainly is getting priced into the insurance premiums for such projects, where risks of fire, flood and other extreme events are high, he observes.
From the point of view of debt funds investing in CRE in the US, one of the immediate consequences of climate risk is the need for greater transparency. Fund managers will necessarily demand it from their borrowers, and their investors will in turn demand it from them.
“The pressure has been rising and this will continue,” Branson says. “It is not merely a matter of regulatory pressure. Much of it comes from private and public pension funds, with their long-time horizons.”
Sun Belt to Rust Belt?
Branson also believes climate change will alter which geographical areas attract the most real estate lending. He was, from 2011 to 2018, the chief executive officer of the National Association of Real Estate Investment Managers. Given his years of experience in the field, it was a matter worthy of note when AFIRE hosted two podcast episodes of Branson discussing the consequences of climate change for the ‘Sun Belt’ region of the US.
Branson contends that the appeal the Sun Belt has had, as a region of economic growth where talented people want to live, exists largely because of the sunny hospitable climate. CRE investment opportunities have been part of this growth. But the arbitrage window may be closing due to changes in climate and the disastrous impact it can have.
In the near future, he expects ‘Rust Belt’ markets like Rochester, Chicago, Cleveland and Milwaukee to become the site of the hot real estate opportunities, inclusive of commercial real estate. Their climate might actually become more comfortable in some respects, and the real estate is selling at prices that do not necessarily reflect that.
In conclusion, CRE lenders in the US will want to keep in mind that there is a relationship between environmental factors and the risk of defaults. The environmental factors can be as dramatic as a hurricane. Or can be as subtle as the gradual change in temperature over a period of years. Lenders who work this relationship into their investment decisions will benefit in their bottom line.
There was an old conception of ESG factors as screens, and of investors who employ them as ‘screening out’ inappropriate entities. But the above material illustrates how ESG may be seen as scooping in, not screening out. Institutions looking to invest in lenders might want to screen in precisely those who are actively aware of sustainability issues.