- Climate risk comes in several forms. There are acute risks of flooding and storms, as well as long-term risks from rising temperatures and figuring out how to manage the transition to a decarbonized world.
- Real estate is a growing part of institutional portfolios and may need to be considered in a broader context — whether in relation to the total portfolio or within society. Investors may seek real estate risk, inclusive of climate risk and technological disruption.
- Despite the adage, the drivers of real estate risk and returns have been more diverse and complicated than “location, location, location.” Beyond geography and sectors, drivers such as cash flows and amenities have historically affected risk, return and value.
Will building skyports for flying cars become the latest “must have” feature for luxury residential buildings? Will there be human settlements on Mars? Despite decades-old predictions, it doesn’t appear that they will revolutionize real estate anytime soon.1 However, there are trends that have impacted real estate in the near term, ranging from climate risk to improved data availability — which suggests that 2020 will be a watershed year for the way investors think of real estate as an asset class.
Real estate has evolved from a relatively small, insignificant and difficult-to-understand element of multi-asset-class portfolios, which traditionally have been dominated by equities and fixed income. Over time, real estate has become a larger part of institutional portfolios.2 Combined with the shift to index-based equity portfolios, real estate’s relative contribution to total active risk and running costs has come under increased scrutiny.
Thus, understanding what drives risk and return in this complex and diverse asset class and how this relates to broader portfolios has become more and more important. In addition, real estate’s evolving role — how it affects the environment and society at large — is becoming increasingly important. We believe that context will continue to be key.
1) Climate risk: Getting to the bottom line
For many years and to many investment professionals, climate risk seemed like an abstract problem for the future. Over the last couple of years, society has woken up to the urgency of the problem. It is a risk that we now see materializing over the typical holding periods of real estate investments. As a result, mitigating and managing these risks are likely to be today’s problems, not tomorrow’s.
Recent, obvious climate risks have been physical ones; and of these, the acute risks of flooding and hurricanes have often been the most immediate and tangible.3 Many real estate investors confront a world where the insurability of these risks may change even within a real estate investment’s expected holding period — typically five to 10 years. In contrast, chronic physical risks could be the “slow burn” risks that materialize over a longer period of time. A good example is potential differing warming cycles and the gradual impact on the costs associated with staying cool. Balancing the costs of retrofitting cooling systems against potential impacts on building values will likely become a concern for investors over the coming years.
Looking beyond more tangible physical risks, an analysis of transition risk may be warranted. It is widely accepted that society needs to decarbonize if it is to avoid a global warming point of no return.4 Transition risk captures the financial and investment impact of these efforts, across a range of decarbonization scenarios.
Historically, better financial metrics have often provided for best risk management. We suspect this will also be the case for assessing climate risks for real estate investors.
2) Places are for people
Ultimately, real estate provides space in which people do things, whether it’s sleeping, working or playing. The need and desire for people to do things in a particular space drive its attractiveness to customers and occupants and, by extension, its value for owners.
No building is an island, cut off from all around it. Each investment is inextricably linked to the built environment, community and society that surround it. For instance, inner-city regeneration projects have historically demonstrated the possibility of attractive short-term investment returns, as well as much broader, long-term positive impact on nonfinancial societal issues such as local employment and social cohesion. And these links can work both ways. Improving the characteristics of a local area or city may have longer-term benefits for the asset. Factors such as housing affordability, diversity, quality of human capital and employment opportunities are increasingly being addressed in the assessment of attractive cities for investment.5
We have observed that environmental, social and governance (ESG) concerns are becoming systematically integrated into investors’ investment processes across asset classes, and clients tell us more attention is being paid to these social and societal impacts — the “S” in ESG. Whether or not motivated by social-impact concerns, real estate investors in general might wish to consider how ESG issues may impact the risk-return characteristics of their investments and portfolios.
3) The many dimensions of real estate risk
Real estate is a complex asset class. There are a great many dimensions of risk that combine in a myriad of different ways and reflect its high degree of heterogeneity. At the asset level, investors and managers may do a great job identifying and actively managing specific risks to a business plan. However, these asset-specific risks have historically not existed in a vacuum. They have been affected by high-level macro risks like changes in economic growth and interest rates.6 It is difficult to model and comprehend how this multitude of risks combines in a single asset across various possible states of the world — let alone how these risks would aggregate across large numbers of assets in a portfolio.
Top-down macro risk analysis and bottom-up specific risk analysis at the asset level have generally been separate exercises, performed by separate teams. But investors increasingly realize they are inextricably linked. When real estate was a small part of multi-asset-class portfolios, this separation might not have mattered. But as allocations have increased, investors are aiming to model specific risks in a consistent, quantitative and integrated way. Addressing these analytical challenges will become a greater focus.
4) Beyond ‘location, location, location’
The drivers of real estate value have almost always been more diverse and complicated than the adage “location, location, location” would suggest. Real estate investors recognize this complexity, but a huge amount of strategic analysis is still constrained to sector and geography. However, we have observed that investors seem more aware that risk, return and value are driven by a broader range of factors. Lease structures and tenant strength have often been among the drivers of growth and resilience of cash flows. Physical attributes of a building such as floor-to-ceiling heights, amenities and energy efficiency have often affected attractiveness to tenants, as have the characteristics of the micro location in terms of transport connectivity, walkability, footfall, etc.
Continual improvements in technology mean more data can be generated, collected and processed more efficiently to help understand these drivers. In the past, many of these nonmarket drivers of value were hard to quantify in any systematic way and therefore were attributed to stock selection or idiosyncratic risk. However, many of these drivers could well have systematic elements to them that affect value across a broad range of assets through the real estate cycle. In the same way that factor analysis has gradually chipped away at specific risk in the equities market, a similar analysis might be made of real estate assets.
5) Everything is relative, and only that is absolute
Real estate investment has historically operated with a dearth of data and metrics. Analytical information that was available was often different from that for other asset classes; and there seemed to be little need to formally wrap that analysis into overall portfolio management.
Broad economic and market forces have been shown to impact individual property investments, and asset-specific characteristics may lead to widely different effects.7 Even the most opportunistic development projects, with extremely high levels of project-specific risk, have been subject to market risk, whether it’s the level of market rents at the time of completion or the pricing environment when an investor seeks to sell a property.
Relative market comparisons can help place performance in context and provide insight into drivers of return, for fixed and absolute-return portfolios.
Asset allocators have increasingly expressed interest in the risk-return and correlation characteristics of the investments they make and what they may bring to the broader portfolio, and real estate is increasingly thought of as part of a real- or private-asset allocation. Managers may wish to demonstrate what investments will and do contribute in terms of the return and risks specific to an investor’s portfolio. That effort may require a new level of data and analytics.
Better tools yield deeper understanding
Investors are asking ever more numerous, sophisticated and varied questions about their real estate exposures. Whether addressing climate risk, broader societal issues or total portfolio risk, investors are seeking enhanced tools to better understand their exposures. As we progress through the coming decade, we may see more investors leverage analytical and data-driven insights within their investment processes — but unfortunately no flying cars or settlements on Mars.
1Numerous technological barriers stand in the way of these innovations. See, for example: “Brown, D. “Possibility or pipe dream: How close are we to seeing flying cars?” USA Today, Nov. 4, 2019. Clifford, C. “Elon Musk defends plans to build a community on Mars after downbeat NASA report.” CNBC, Aug. 2, 2018.
2“Cornell Real Estate Review, 2018 Institutional Real Estate Allocations Monitor, Survey Highlights.” 2019. Cornell University’s Baker Program in Real Estate and Hodes Weill & Associates.
3Mollod, G. and Robson, W. “Climate risk in private real estate portfolios: What’s the exposure?” MSCI Research Insight, Sept. 17, 2019.
4“Special Report: Global Warming of 1.5 ºC.” 2019. Intergovernmental Panel on Climate Change.
5Hales, M., Mendoza Pena, A., Peterson, E., and Dessibourg-Freer, N. 2019. “A Question of Talent: How Human Capital Will Determine the Next Global Leaders.” A.T. Kearney.
6Reid, B. “For real estate, all rate rises are not created equal” MSCI Blog, April 25, 2018.
7Mansell, G. “Private real estate: From asset class to asset.” MSCI Research Insight, November 2013.