When you are looking for an empty table in a restaurant, you apply a different filter than when you are looking for a friend who is already there waiting for you. Chances are that you will even overlook familiar faces when focusing on the empty seats.
Investors apply different filters in the due diligence process, one after another in a systematic way. We may build a financial model, price the assets, assess the management, look at environmental liabilities, etc. A large part of this exercise is about downside protection. Your favorite holding period is “forever” and you prefer to invest in companies that any idiot can run? Then take your time and identify all risks that could bring your target in jeopardy. And make sure the biggest risk is not the guy doing due diligence. Like he is approaching all data with an incomplete checklist so that he misses risks that are relevant to the target and obvious - but again, only to those who apply the right filter.
Category A risks
A good starting point for putting together your list of category A risks is The Global Risks Report provided by the World Economic Forum. Take a look at the Global Risks Landscape right on the first page.
The risks shown in the top right corner are the ones that are both likely to materialize and potentially very harmful in terms of impact. The current top three risks are:
- Extreme weather events
- Failure of climate change mitigation and adaptation
- Natural disasters
Some say, “in the long run we are all dead.” Sure, or in the short run, if we choose to ignore risks. So, mapping risks is imperative if your favorite holding period is “forever”.
"Buy land, they're not making it anymore"
Real estate investing is about getting your hands on attractive assets that can neither be replicated nor moved. Investors appreciate that there are no bypasses on a Monopoly board. However, imagine how the game changes once you add, say, rising sea levels to the picture. Suddenly, the cost side of things becomes more noticeable up to the point where your monopoly on an immovable asset does not guarantee you any income but an instant and complete loss.
Insurance we trust
It may be difficult for individual investors to assess global warming-related risks. Luckily, it is not necessary to build a climate model on your notebook, when experts have done the work already. Insurers are an excellent starting point. Let’s take a look at the risk factors sections of two 10-Ks. Which stock would you feel more comfortable holding (emphasis added)?
There are [..] some losses, including losses from floods, windstorms, fires, [...], that are not generally fully insured against.
Generally, Company B’s properties are covered by all-risk policies that include apart from standard components such as protection against fire, storm and water pipe damages also losses from natural hazards such as high tide, floods or snow loads.
The first example is from American Homes 4 Rent's (AMH) 2016 10-K. One year later, in 2017, some 3,500 of the company’s properties were hit by the hurricanes Harvey and Irma, causing uninsured write-downs and repairs of $8 million. Small change? Well, in the case of AMH, $8 million is equivalent to 20% of the dividend payments to common stockholders. Call me conservative, but I would prefer Company B (which, by the way, is a German company called VIB Vermögen AG (OTC:VIBVY)).
Do not take risks insurers refuse to take. Or, to be precise, do not take risks insurers and taxpayers refuse to take. Why taxpayers? Because in the U.S., adequate private flood insurance is unavailable for floodplain properties and the Federal Emergency Management Agency (FEMA), and ultimately, the taxpayers are stepping in as insurers of last resort.
Recently, FEMA announced the introduction of what they call Risk Rating 2.0, which “will help customers better understand their flood risk and provide them with more accurate rates based on their unique risk.” In other words, the insurer of last resort is raising the price where the risk exposure is high. Thus, a look into the crystal ball tells me the number of virtually uninsurable properties is about to go up. With the insurance cover gone, mortgages will become unavailable for these properties as well. The devil takes the hindmost.
Another useful source of information is Four Twenty Seven’s report, "Climate Risk, Real Estate, and the Bottom Line." Four Twenty Seven has assessed the exposure to climate-related risks for 73,500 properties owned by 350 listed REITs and concluded that 35 percent are exposed to climate hazards. The REITs with the highest risk score are all based in East or Southeast Asia: Champion REIT, Hysan Development Company (OTC:HYSNF) and Fortune REIT.
I am no big fan of technical analysis, but here is one exception: sea level rise.
I would love to be wrong, but to assume that this trend will reverse anytime soon is wishful thinking. And if you are long Vornado Realty Trust (VNO) or Equity Residential (EQR), this trend is working against you. These REITs have 13-15 percent of their portfolio exposed to sea level rise, and you may want to look out for “sub-limits for certain perils” when checking their insurance cover.
As I was going through the information for this article, it dawned on me that the guy with the incomplete due diligence checklist had been me. I used to be long CapitaLand Limited (OTCPK:CLLDF), a Singapore-based REIT. According to Four Twenty Seven, 30-40 percent of that REIT’s portfolio are red flag properties, meaning they “fall in the 5 percent most exposed properties of all facilities scored by Four Twenty Seven’s global database of over 1,100,000 corporate facilities.” And perhaps it does not even require the machine learning Four Twenty Seven uses to figure out that real estate in places like Jakarta or Fiji is no safe harbor for retirement savings. Anyway, when I checked the section on risk management in CapitaLand’s annual report, I saw the REIT does recognize climate change risks and even confirms it would make mitigation and adaption eﬀorts. However, it fails to be more specific than that. Insurance we trust. And I decided to hit the "Sell" button.
Not everybody will agree with the above. I welcome differences in opinion. They allowed me to sell my shares in CapitaLand swiftly and at a small profit. I really hope that those who disagree with me are correct and I am wrong. The odds are just not in your favor. Global warming-related risks are here to stay, and they will not only impact real estate. “Climate change is something we have to include in every single analysis, every investment”, says Autonomy Capital’s Robert Gibbins. I agree and hope with regard to the shortcomings of my own past analyses that I stay ahead of the pack and recognize risks before others do. The devil takes the hindmost.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.