REITs and Climate Risks: Financial Impact and Its Mitigants
February 23, 2023
By Lourenco Miranda
The proposed SEC rules for Climate-Related Disclosures require public companies, including real estate investment trusts (REITs), to disclose information about their climate-related risks, governance, management processes, greenhouse gas emissions, financial metrics, and climate-related targets and plans. This information would be included in their registration statements and periodic reports. The proposed disclosures are like those recommended by the Task Force on Climate-Related Financial Disclosures (TCFD) and the Greenhouse Gas (GHG) Protocol.
Public REITs would be required to disclose their processes for identifying, assessing and managing climate-related risks including any transition plan, scenario analysis and internal carbon price. They would also need to report on their direct and indirect greenhouse gas emissions and their progress towards meeting any publicly set climate-related targets or goals. The purpose of these proposed rules is to enhance and standardize climate-related disclosures for investors to inform their investment decision-making.
The Impact Climate-Related Risks Have on REITs
REITs are exposed to climate-related risks, which can negatively impact their business models, financial performance and sustainability overall. Aside from the physical risks associated with climate change, such as flooding, sea level rise, and extreme weather events, there are also transition risks associated with climate change, such as changes in regulations, energy prices and tenant preferences. Here we are going to explore the possible financial consequences of climate-related risks on REITs as well as strategies to manage these risks in order to minimize their financial impact.
Physical Risks and REITs
As a first step, we analyze the impact of physical risks on REITs. Climate change makes them vulnerable to physical impacts like flooding, hurricanes and wildfires, which can damage or destroy properties and disrupt operations. Property values may decrease because of property damage and insurance costs may rise, which can significantly affect a REIT's financial performance. Due to property damage or unsafe living conditions, tenants may have to vacate properties, resulting in a decline in rental income. In order to reduce exposure to specific physical risks, REITs can invest in resilient infrastructure and disaster preparedness, therefore fortifying their property holdings.
Transition Risks Related to Climate Change
Transition risks related to climate change can impact REITs’ profitability and business model. Transition risks that may affect REITs materialize through changes in energy costs, building codes and regulations. For example, new energy efficiency regulations may require REITs to retrofit or upgrade existing properties to comply with new standards, which can increase operating costs for a brief time. In addition, changing market demands and shifting tenant preferences may make certain properties less desirable, which could impact property valuations and rental income. REITs can mitigate these risks by investing in sustainable properties and technologies, as well as adopting sustainability strategies that reduce operating costs and increase tenant demand.
Financial Implications – Hurting the Bottom Line
The financial implications of climate-related risks for REITs can include increased insurance costs, higher maintenance/repair expenses and lower rental income. In addition, climate-related risks can impact the cost of capital for REITs, affecting both debt and equity financing. REITs that proactively manage climate risks and implement sustainability strategies may be better positioned to reduce the impact of these risks and maintain lower cost of capital.
What Could Be Done to Mitigate Those Risks?
For REITs to manage climate-related risks, they can adopt a range of strategies, such as adopting sustainable practices and implementing risk management strategies in addition to investing in sustainable properties and technologies. It is possible for REITs to reduce the risks posed by climate change by improving energy efficiency, reducing emissions and improving the resilience of their properties. There are also ways in which REITs can work with an organization's tenants, suppliers and other stakeholders in order to manage climate-related risks.
Working Toward a More Sustainable Future
Climate-related risks pose a significant challenge for REITs, and they are likely to have a greater impact on their business model and financial performance in the future. Investing in sustainable properties and technologies and implementing sustainable practices can help REITs minimize climate-related risks while maintaining long-term financial stability. In a challenging regulatory environment and changing climate, REITs that demonstrate a strong commitment to managing climate-related risks and implementing sustainable practices are likely to be more attractive to investors.