We believe the answer is to quantify the risk for individual properties based on models that consider specific types of potential disasters region by region. Through this in-depth analysis, investors can better understand CMBS risk exposure and either demand better pricing on riskier deals or avoid them altogether.
For a single loan, the evaluation can usually be completed using publicly available data. Many investors actively seek investments in properties that are Leadership in Energy and Environmental Design (LEED) certified, as the market considers those securities green. LEED provides a framework for healthy, highly efficient and cost-saving buildings, and the LEED rating depends on the level of sustainability.
While green investment opportunities can be compelling, it isn’t enough. A LEED certification on a property is only a starting point for climate-related investment analysis and can camouflage other climate threats. After all, even LEED-certified buildings are still subject to the environment around them.
Consider a LEED-certified property in Florida, a transportation hub promoting rail service, encouraging less car usage and fewer emissions. The underlying property carried storm and storm surge coverage when the security was issued, which covers hurricane damage. The building is not in a FEMA-designated flood zone, making it a seemingly sound green investment at first glance.
Further analysis, however, revealed that the building owner has the right to drop the insurance for any reason; the loan agreement doesn’t require flood insurance since the building isn’t in a designated FEMA flood zone. Plus, floods disrupt tenants and their businesses, hindering both cash flow and future leasing prospects. Some investors might find these risks worth taking, especially for a LEED-certified property. But in this case, the valuation didn’t compensate for those risks.
Assessing Climate Risks in Bulk
Incorporating ESG analysis with credit analysis is an easily manageable process for a single loan, but most CMBS are much more daunting packaged bundles of 40 to 70 loans.
Most investors—indeed, many managers—aren’t equipped to broadly assess these underlying CMBS risks. Those wishing to get ahead of the pack need to deploy property-specific hazard information that may be available from data providers, and then model those property analyses across complex deals that include dozens of property loans.
A better understanding of those risks may not be fully rewarded today, because the CMBS market doesn’t price in those risks, either broadly or individually. In fact, there’s little to no pricing difference based on climate risk (Display). However, until this changes, investors who accurately assess environmental risk can get a step ahead by choosing bonds that have less climate risk without sacrificing yield spread.
