Investors and operators across commercial real estate are anxiously awaiting the finalized rules from the SEC, which are expected to be released in spring 2023.
This article will focus on material risk and kicks off a three part series in anticipation of the new rules, broken out by each of the broad categories laid out in the SEC’s draft that came out last year:
- Material risk
- Carbon accounting
- Transition plans
The goal is to demystify climate disclosure rules, disseminate the best practices of leading portfolios, and offer helpful resources for getting started.
Why should we care?
Obviously, publicly-traded REITs need to pay close attention to the rules and regulations of the SEC. When the rules are finalized, they will have a direct impact on what needs to be included in annual and quarterly reporting to shareholders.
However, while the rules apply directly to publicly traded companies, there are implications up and down the value chain of commercial real estate.
For example, property management companies that provide services for REITs will be expected to help comply. Already, the number of requests to ESG-related reporting has become a burden for many property managers and without systems in place, will detract from core responsibilities.
Likewise, private owners with JV partnerships that include REITs may need plan for investments so their partners can meet their compliance requirements.
And of course, many commercial tenants are publicly traded companies that will need data from their spaces to comply. While tenant engagement has been a focus for the last few years, this is an area where most landlords are underserving their tenants.
What is materiality risk?
Broadly, risk is made up of probability and damage.
As the effects of climate change worsen over time, both the probability and damage to physical assets increases.
Going forward, The SEC's climate disclosure rules will require companies to disclose any material physical risks related to climate change in their public filings.
These include hazard events affect by climate change, such as:
- Hurricanes
- Extreme rainfall/flooding
- Extreme temperatures
- Drought
- Wildfire
- Landslides/Mudslies
- Dam/levee failure
And it’s not only the direct damage caused by these sources.
For example, a property located in a flood zone may face higher insurance premiums, lower occupancy rates, and increased maintenance costs.
How do we get started?
There’s an alphabet soup of ESG reporting frameworks, creating an air of confusion and frustration for anyone who’s core responsibility doesn’t include ESG or sustainability.
For simplicity sake, most landlords focus on reporting to Global Real Estate Sustainability Benchmark (GRESB) because it is built for real estate.
In terms of determining materiality risk from climate change, the Urban Land Institute lays out a five-step process in their Building Healthy Places Toolkit
Step 1 - Define types of relevant hazards
Make a list of the types of hazardous events that could have a serious impact on an asset.
Step 2 - Define event scenarios
For each event type, develop two to four scenarios covering a range of low to high impact of that event, then assign an annual probability of occurrence for each scenario.
Step 3 - Assess the damage to the asset
Estimate damages for all the types of hazards for all scenarios across all event types.
Step 4 - Calculate annual risk exposure
For each event type and each asset, create a risk curve, then calculate the annual risk exposure by esimating the area under the curve.
Step 5 - Calculate cumulative risk exposure
Perform steps 2 through 4 again to estimate scenarios, probabilities and damages for future years, then calculate the net present value of all future annual risk-exposure values to understand the total risk an asset faces.
What outputs does the SEC expect?
Following the above outline, a portfolio should end up with a series of tables and charts outlining different risk profiles of assets and the broader portfolio.
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