Climate Change and Real Estate Investing
Should I Bid for a Bozeman, Montana Property?
On my Twitter feed, I recently posted this link to a Zillow listing of a 31 acre lot for sale in Bozeman, Montana. I have been to Bozeman five times and in total have lived there for 8 weeks. I have been thinking about buying some land up North to diversify my investment portfolio.
My friends on Twitter were quick to point out that this area now faces elevated PM2.5 levels due to fires burning in the American West sending smoke to the area. You can read about Bozeman’s current PM2.5’s levels here.
Every asset whether it is a stock, bond, bitcoin, a brain, or a piece of property can be described by its expected average rate of return and the variation in this rate of return; put simply its return and its risk. U.S Treasury Bills offer a low risk, low rate of return. Bitcoins are the opposite. How might climate change affect different pieces of real estate’s risk and return?
Point #1: We must live somewhere. Einstein wrote about relativity. Relative comparisons matter in making choices. If America features two locations called San Diego and Bozeman and if climate change injures both because they both become hotter and more fire prone but if San Diego suffers more then real estate prices will rise in Bozeman. This “relative” competition has several implications. I sketch this out in my 2010 piece that you can read here. Those areas that fail to deliver quality of life in the face of climate change as compared to other locations —- so they decline in relative quality —— will experience a drop in local property values. Over time, climate change is not the only trend to play out. I believe that Work from Home will stick (my 2022 book further explores the economic geography of this trend). To see a preview of my thinking read our 2021 NBER paper. WFH increases the demand to live in places such as Bozeman, MT.
Point #2: This expected dynamic gives local property owners a strong incentive to increase their location’s adaptation to the new risks. How they achieve these risk reduction gains depend on a case by case basis. We are not passive victims in the face of rising climate change risk. Different locations will face different threats but the residents of affected areas and the owners of productive firms and the owners of valuable assets have strong incentives to invest in self-protection of these assets.
This demand for innovative solutions fuels product innovation. I explore this point in this 2018 paper. If a Berkeley , California grows hotter in summer ; demand for air conditioning rises . If enough people around the world demand air conditioning, then innovators will invest more time and effort to pursue solutions and some will succeed. Purchasing and operating such products helps to mitigate the damage caused by increased heat and elevated PM2.5 levels. Yes, his ramp up in air conditioning can contribute to rising GHG emissions but a greener grid can offset that. The point of this example is that rational forward looking individuals calmly evaluate new emerging threats and choose what is their best path forward. This is the microeconomic approach to thinking about climate change adaptation.
Economists call this “induced innovation”. Given the ongoing political decisions about decarbonization, many economists are uncomfortable with using the tools of our field to think about adaptation because they anticipate that this path of thinking leads to “excess optimism” about ability to cope with threats. The old Paul Ehrlich versus Julian Simon debate resurfaces.
Point #3: All economists know that the key input in the modern economy is human capital. It isn’t gold or land. When we develop skill, we have an increased likelihood to solve hard problems. Climate change poses hard new problems for us to solve. Land that retains its amenity value and productivity value will be a valuable asset in one’s portfolio.
I will not put all of “my eggs in one basket”. I know that I do not know what climate change will do to the quality of life of each location in the U.S. I am thinking about which areas will compete relatively better than others. This competition between places to have the Best Quality of Life in 2050 actually helps all of us to adapt to the new risks.
If this line of logic interests you, take a look at my new book published by Yale University Press titled Adapting to Climate Change.
If you are only interested in free material, then click here to read Climatopolis Revisited.
Here is a video where I discuss these issues.
In this column, I have implicitly assumed that the real estate buyer pays with cash and doesn’t borrow money to buy the property. There are also issues pertaining to insuring such properties in the face of climate change. In future columns, I will return to these issues.
For a preview about mortgage finance, read my RFS paper joint with Amine Ouazad.
For my thoughts on insurance, read my Harvard Business Review piece.
Finally, a check-list for those looking for practical advice.
When you consider bidding for a given property, what do you currently like about the property?
What threat does climate change pose to your priority list? (i.e excess heat, pollution)
What is the likely timing of when these risks will materialize?
At what cost can you partially offset these risks through your own investments or through government provision of protective policies or local public goods?
What product innovations would help you to offset this risk?
What strategies do you have to avoid the rising risk? (so if Bozeman is more polluted during the Summer fire season —- can you live somewhere else then?)
What is your edge in adapting to the emerging threats relative to other people?
Note that this person specific microeconomic approach to adaptation is a very different mindset then what you see in the Nordhaus Damage Function approach. He won the Nobel Prize but I think that the microeconomic approach is the right way to think about true economic impacts of climate change.
Finally, as I discuss in my 2021 Yale Press book, for those who are risk adverse and know “that they do not know” how a specific area’s quality of life will be affected by climate; such individuals can choose to rent rather than buy. Renters hold a real option to delay locking in and making a place based bet. The microeconomic ideas of Dixit and Pindyck on real options are highly relevant here.
Returning to the start of this piece, recall that I mentioned that a friend is worried that Bozeman real estate prices will decline in the future because of rising PM2.5 levels caused by ever more intense fires in the American West. Suppose that an investor agrees with him, how can an investor make a bet that Bozeman real estate prices will decline? The ability to short real estate local price indices over the medium term would fuel adaptation through price discovery.