Journal of Financial Planning: June 2024
NOTE: Please be aware that the audio version, created with Amazon Polly, may contain mispronunciations.
Samuel Adams is CEO and co-founder of Vert Asset Management. He co-authored Your Essential Guide to Sustainable Investing with Larry Swedroe. He is a member of the Plan Sponsor Council of America’s Investment Committee. Prior to launching Vert, Sam spent 20 years at Dimensional Fund Advisors.
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Sustainable investing seems to be getting more confusing and controversial by the day. It’s hard to determine which companies are behaving responsibly, which investment managers are greenwashing, and what to expect with performance.
Real estate provides us some relief from this confusion. Sustainability in real estate is often a more straightforward proposition than in other types of investments. Buildings are tangible, and many of us have more direct experience. Most of us have paid a utility bill, and many of us have winced when we see those spikes in the summer for AC and in the winter for heating. Additionally, more and more of us have endured a storm strong enough to cause physical damage to our homes or cause a temporary power outage.
We can connect the dots. If we want lower utility bills, we might need to invest in insulation or a more efficient HVAC system to use less energy. If we want a resilient home, we might need to stormproof or invest in a backup power system. These improvements can be costly, so ultimately, these considerations become investment decisions. Is it better to invest capital up front to benefit from lower costs and fewer disruptions over the long term? What is the payback on that installation of solar panels, heat pumps, storm windows, or smart thermostats? How can I lower the overall costs and risks of ownership? What is the best way to improve the value of my property? These are economic decisions, but they are sustainability decisions as well because, in real estate, the two are linked.
Corporate owners of real estate are making the same calculations, just on a bigger scale. They tend to have more access to capital to make it easier to invest in those solutions. But on the flip side, if they are publicly traded, they need support from shareholders to make those long-term investments as the benefits won’t immediately boost their quarterly earnings.
Financial planners have multiple opportunities to help their clients with sustainability in real estate: first, with their investment portfolios; second, with the real estate they own or rent directly; and third, in their retirement planning.
What Matters for Sustainability in Real Estate
Forty percent of global energy is consumed by buildings, creating 33 percent of global greenhouse gas (GHG) emissions (Tricoire 2021). Buildings also create 12 percent of our waste and use 10 percent of our clean water (USGBC n.d.). And they can have an outsized impact on biodiversity depending on how and where they are built. Real estate has a big environmental impact.
Humans spend 90 percent of their time indoors. The buildings we inhabit have a big impact on our health and well-being. We rely on them to keep us safe. We use them to connect with others in our social circles and our communities. Real estate also employs 10 percent of the global workforce. In many countries, there is a housing shortage and/or an affordability crisis. Real estate has a big social impact.
These outsized environmental and social issues create opportunities for investors. There are dozens of opportunities for investors to add economic value while simultaneously helping people and the planet. The most pressing issues are often the most material and, therefore, provide the most opportunity. In real estate, three of the top concerns are:
- The physical risks from climate change
- Energy and emissions
- Affordable housing
Reducing Risk in Real Estate
Experience has taught professional real estate investors to protect their portfolios from market shocks like interest rate hikes or economic downturns. For example, REITs switched to longer-term fixed-rate debt after the 2008 financial crisis, and they now stagger their tenant leases so they aren’t exposed to multiple vacancies simultaneously. A new set of risks are arising that we are just now learning how to deal with—the risks from climate change.
When the storm is coming, or the wildfire smoke gets too thick, we can often move out of harm’s way, at least for the time being. But we can’t move our buildings. We need to make them resilient. Most buildings were generally designed to the building code of the time of their construction, and those codes were drafted based on assumptions of normal weather variation in those locations. You have probably noticed the weather hasn’t been behaving “normally” of late.
Climate change makes for more frequent, and more intense, storms. Wind speeds are higher, rainfall is more intense. We now have “heat domes” settling in for weeks at a time, and wildfire smoke makes our air unhealthy. Sea level rise is affecting some neighborhoods on a regular basis. In 2021, 14.5 million homes were affected by climate-related hazards amounting to $59.6 billion in damages from large events (CoreLogic 2022). An estimated 59.9 million homes in the United States are in areas with at least moderate expected annual losses from climate-related hazards.
Clients have three options: divest, hope for the best, or invest.
Divesting isn’t always practical—particularly if you live or work in your building. And selling anything that might be affected by storms might knock half of the United States out of your portfolio.
Hoping for the best is just a delay tactic. Eventually the bill will come, and maybe before the storm even hits. Insurers are raising prices, and in some areas, they are refusing to insure at all.
The third option, invest, remains. Buildings can be retrofitted to be more resilient. When the roof needs replacing, build it stronger than before. When the HVAC is getting on in years, replace it with a heat pump. Install landscaping and drainage that can absorb twice the rainfall that code expects. Plan for power outages—have backup batteries or generators installed. These are high up-front capital investments, but they will prove their worth in the worst of times.
If your client owns property directly, encourage them to get an updated assessment of its resiliency. The code it was built to was probably not written with today’s climate in mind. If they own a real estate fund, ask the manager how they screen companies for the physical risks in their portfolios.
Energy and Emissions
Many of us want to reduce our own personal carbon footprints. For many corporations, it’s become a commitment.
Sixty-six percent of the companies in the Fortune Global 500 have set a net-zero target, meaning they have committed to reducing their emissions to zero, or at least to a point where they can offset the remaining emissions, by the year 2050. Companies that have set these targets include tech giants like Google, Meta, and Apple but also American Airlines, McDonald’s, Netflix, Disney, and Ford Motor Company. More than 7,500 companies around the world have set a science-based target to get to zero carbon by 2050.1 The commitments to decarbonize our economy are growing as the threat of climate change gets more real.
The companies aiming to lower their carbon footprint will want to consider the emissions of the buildings they use in their business. If they are buying buildings, they will want them to be low carbon. If they are renting, they will want them to have low emissions. The demand for green buildings is set to rise as companies strive to lower their carbon footprints.
Fortunately, opportunities to lower emissions in buildings abound. Most existing buildings were built without a focus on energy efficiency. Quite famously, the Empire State Building’s 2010 retrofit reduced its energy use by 38 percent, mostly through installing insulation, double-paned windows, and refurbishing the HVAC system (ESRT n.d.). Best of all, that retrofit paid for itself in less than five years through lower energy costs.
It is estimated that a green building uses 25–30 percent less energy than a conventional one. This not only reduces the owner’s utility bill, but it also reduces the emissions that are assigned to the user. Green is better for both planet and profit.
The opportunity for investors is clear: select real estate owners and operators that have a commitment to green buildings and/or emissions reductions. These firms stand to benefit from the increasing demand for sustainability.
Making More Affordable Housing and Making Housing More Affordable
In 2021, the number of owner households spending more than 30 percent of their income on monthly housing costs reached 19 million, which is 22.7 percent of homeowners. For renters, the number that are cost burdened reached 21.6 million after the pandemic, which is 49 percent of all renter households (JCHS 2023).
Costs are high because supply is low. The National Low Income Housing Coalition estimates there is a shortage of 7.3 million affordable homes for low-income Americans. Decades of under-building contribute to the shortfall (NLIHC 2024).
To properly address the affordable housing crisis, policymakers need to change zoning laws that restrict building and reform the permitting process. In the meantime, the opportunity for investors is to help build or preserve affordable housing given the high demand.
Investors in the public equity markets can look to homebuilders, developers, and REITs that focus on affordable homes, or to funds that prioritize this issue. In the United States, a significant portion of affordable housing is provided by manufactured homes, a segment that several REITs focus on.
Investors who prefer direct ownership of properties can take advantage of a complex web of tax and financing incentives. At the federal level, low-income housing tax credits have helped build over three million homes by incentivizing developers.
Investors who are wary of the zoning and permitting challenges related to new construction have another way to invest in affordable homes. Investors can grasp the opportunities available for making existing housing more affordable.
Utility bills can be 15–20 percent of the total housing cost for both renters and owners. Reducing this burden is not difficult: installing insulation and smart thermostats are low capital commitments that generate big savings.
The landmark but inaptly named Inflation Reduction Act has added multiple incentives for owners to green their properties. There are provisions to assist with solar and battery storage installations, replacing furnaces and AC units with heat pumps and upgrading to more efficient appliances. As it is relatively new legislation, some states are only now updating the incentives they offer. Given that these incentives run to multiple thousands of dollars, they do provide opportunities for financial planners and tax advisers to provide significant benefits for clients.
An oft overlooked opportunity for reducing the cost of housing is in transportation. Car ownership and operation—including insurance, maintenance, and fuel—is expensive. Not needing a car is a huge savings opportunity. This necessitates housing to be available in more urban areas, or at least in areas with services that are within walking distance or accessible by public transport. The suburban sprawl that characterizes many parts of America might not fit this mold. Investors can prioritize opportunities in locations with high walk, bike, and transit scores, or invest in funds that do the same. There is a shift in demand in urbanism, particularly by younger generations, for locales that require less commuting. More investment funds are being launched that seek to advance “transit-oriented development” or “15-minute cities” or “live-work-play communities.”
Planning For Climate Change
Much attention is paid to the financial assumptions we make for planning including expected returns, inflation, interest rates, withdrawal rates, cost of living, etc. Much less attention has been given to climate change. This, forgive the pun, needs to change.
We should not assume, or let our clients assume, that the comfortable retirement destinations of today will be that way in the future. Arizona, historically popular for northerners seeking milder weather, might not seem so attractive in coming decades. In 2023, Phoenix endured 145 days of 100-degree heat. Temperatures topped 110 degrees on 55 of those days. Before 2020, the highest number of days over 110 was 33 days. What will temperatures be like in the 2030s? How much of the year will it be too dangerous to be outside? What is the exposure of a particular property to wildfire or flooding? Is the house stormproof? What will it cost to make it resilient?
Another assumption to reconsider is the cost, and availability, of insurance.
In Florida, the Insurance Information Institute estimated that the average cost of home insurance would rise 43 percent in 2023, reaching $6,000 per year (Freedman and Borney 2023). Some experts expect $10,000 to be the norm in just a few years.
And that is if you can even get insurance. Between 2015 and 2021, over 1.3 million Californians had their fire coverage dropped by an insurer, out of a total of around 10 million total policies in the state, according to data gathered by the California Insurance Commissioner’s office (Freedman and Borney 2023). Perhaps these insurers had had enough—wildfires have caused more than $30 billion in insured losses in California since 2017, according to the reinsurance company Munich Re.
Insurers are leaving higher risk states:
- Florida: Farmer’s stopped renewing auto and home policies in 2023 (Morse 2023).
- California: State Farm and Allstate exited the state in 2022 (Copley, Hersher, and Rott 2023).
- Louisiana: 12 insurance companies withdrew and seven went bankrupt in 2023 (Finch 2022).
Unfortunately for homeowners, houses that aren’t insurable drop in value, often quite drastically. At a minimum, financial advisers should re-evaluate the cost assumptions they put into their models. They should consider the risk that their clients might need to self-insure. That dream waterfront property might eventually become a nightmare.
More than a few financial planners have had experience with a client’s unrealistic assumptions about retirement. Clients often need a nudge to re-evaluate their prior assumptions on healthcare costs or their travel budget. That conversation now might include some realism on climate change and how it might affect their plans—particularly if those plans include living in or near harm’s way. Some questions to ask might be:
- What will the weather be like in the next 10 or 20 years rather than now?
- Will you still be able to golf, garden, ski, or play pickleball like you plan to?
- Will the cost of property ownership become too onerous in that area?
- How many days a year will be stressful due to heat, smoke, storms, or power outages?
- Is it safe to assume property values will continue to rise?
Sustainability: Prudence or Preference?
Sustainability is often just an expressed preference: a choice to buy fair trade coffee or organic milk for example. In real estate it can be that too: a preference for recycled hardwood floors or natural materials. But for many issues in real estate, sustainability is a marker for prudence. Cost savings can be identified. Risks can be assessed. Higher demand may be attained.
By considering the issues around sustainability in real estate, planners can help clients make the most of their real assets: those which they may love most dearly—their homes—and those which they may most rely on in the future—their investment portfolios.
Endnote
- Visit https://sciencebasedtargets.org/ to learn more about the Science-Based Targets initiative.
References
Copley, Michael, Rebecca Hersher, and Nathan Rott. 2023, July 22. “How Climate Change Could Cause a Home Insurance Meltdown.” NPR. www.npr.org/2023/07/22/1186540332/how-climate-change-could-cause-a-home-insurance-meltdown.
CoreLogic. 2022, February 17. 2021 Climate Change Catastrophe Report. www.corelogic.com/intelligence/2021-climate-change-catastrophe-report/.
Empire State Realty Trust, Inc. (ESRT). n.d. “New York’s Sustainability Icon.” www.esbnyc.com/about/sustainability.
Finch II, Michael. 2022, September 27. “Here Are the Louisiana Insurers That Have Gone Broke or Left the State amid Deepening Crisis.” Nola.com. www.nola.com/news/business/here-are-the-louisiana-insurers-that-have-gone-broke-or-left-the-state-amid-deepening/article_c7f077b4-3e98-11ed-86c9-f7f11037202f.html.
Freedman, Andrew, and Nathan Borney. 2023, June 6. “Uninsurable America: Climate Change Hits the Insurance Industry.” Axios. www.axios.com/2023/06/06/climate-change-homeowners-insurance-state-farm-california-florida.
Joint Center for Housing Studies of Harvard University (JCHS). 2023. The State of the Nation’s Housing 2023. www.jchs.harvard.edu/state-nations-housing-2023.
Morse, Hannah. 2023, July 14. “Farmers Insurance Is Leaving Its Business in Florida.” USA Today. www.usatoday.com/story/money/2023/07/11/farmers-insurance-leaving-florida-market/70403832007/.
National Low Income Housing Coalition. March 2024. The Gap 2024: A Shortage of Affordable Homes. https://nlihc.org/gap.
Tricoire, Jean-Pascal. 2021, February 22. “Why Buildings Are the Foundation of an Energy-Efficient Future.” World Economic Forum. www.weforum.org/agenda/2021/02/why-the-buildings-of-the-future-are-key-to-an-efficient-energy-ecosystem/.
USGBC. n.d. “Benefits of Green Building.” www.usgbc.org/press/benefits-of-green-building.