The US commercial real estate lending market is not immune to the impact of climate change, with a new report from SitusAMC cautioning lenders and borrowers to be aware there could be a disconnect between rising insurance costs in disaster-prone markets and the financial health of properties.
As the US continues to see a steady rise in the number and severity of natural disasters like hurricanes, tornadoes and wildfires, lenders and investors should also expect to see insurance costs rise, said Peter Muoio, a senior director and head of SitusAMC’s Insights group. The New York-based technology and services provider cautions, however, that lenders and borrowers might not always be ready when premiums rise.
“There may be some disconnect between the cost increase curve and assumptions on costs being used by some real estate investors,” Muoio said. “This can lead to cost-side surprises for real estate investors and lenders. If the cost increases are substantial enough, the estimates can overvalue certain properties.”
It is difficult for tenants and owners to understand and predict the factors which can rapidly put pressure on insurance costs. Muoio notes that property valuers are modeling a 10 to 15 percent growth rate for insurance costs in year one and roughly 3 percent inflation-linked increases for the remainder of the holding period. But premiums on properties outside of catastrophe-prone zones should be expected to rise 5 percent to 10 percent, while properties inside catastrophe zones may see premiums rise between 10 percent and 15 percent each year, Muoio said.
One concern, however, is insurers that are telling SitusAMC there are too many potential problems for accurately predicting increases, including the availability of insurance. “These trends – an increase in the number and severity of natural disasters associated with a worsening climate, a more consolidated market and lingering damage from covid-19 – could keep annual rate hikes higher in the near future,” Muoio said.
Property damage from natural disasters isn’t limited to coastal markets like South Florida. Despite the headline risk around individual situations in Florida and California, the areas which saw the biggest impact from natural disasters in 2021 were in Texas, Virginia and South Dakota.
Additionally, there is a strong correlation between the markets in the Western and Southeastern US, which are seeing population growth and natural disasters, with Muoio noting that fire-prone parts of the West and flood-prone areas of the Southeast are becoming population magnets. The report also found that 1.2 million residential units and another 66,000 commercial units are at risk for flooding over the next 30 years. This is an increase of 10 percent and 7 percent, respectively.
“Some of the states with the largest population inflows over the past several years are also mired in a drought – much of the Mountain West and Northwest – and are likely to face ongoing fire threats from a drying climate,” Muoio said. “Experience from California suggests as the population grows, residents will push farther away from the metro core in search of affordable space. The sprawl abuts development with vegetation and fire-prone areas. Soon, about 35 million people in four states – California, Texas, Arizona and Nevada – will live in fire-prone areas.”
So far, most insurers have remained financially stable, even with the mounting pressures around climate change. Still, national carriers with exposure that is spread around the country are in the strongest financial position while smaller carriers and reinsurers are in slightly worse shape, according to Muoio.
“Many financial filings by top insurers and reinsurers separated out losses to include and exclude the strain felt from catastrophe outlays,” Muoio added. “The separate combined ratios – the ratio of losses/expenses to gains– differed by as much as 5 to 10 percent, indicative of the pressure put on insurers by these catastrophes.”
As always, leverage is a factor and real estate lenders are aware of the rising risks. As a mitigant, lenders are mandating greater analysis of carriers, including financial ratings and how coverage is executed in the event of losses to protect the assets.
“The highly leveraged nature of commercial real estate makes the market particularly susceptible to increasing insurance premiums as cutting coverage is not an option to mitigate risks,” Muoio said. “Most real estate lenders require some sort of minimum coverage, but commercial real estate lenders set a much higher benchmark for minimum coverage because of the high prices.”
There are several things commercial real estate lenders can do to mitigate the risk around climate change and their lending portfolios. The condition of individual assets and their ability to weather disasters, conformity to international building codes around floods, earthquakes and hurricanes in disaster-prone states like Florida, Texas, California and South Carolina also have a positive impact.
Finally, there are certain markets and property types which might demonstrate enough rent growth to mitigate rising costs in operating expenses. “For many properties, insurance occupies only a small part of total expenses – sometimes as low as 2 percent – meaning property managers can offset a rise in insurance rates via moderate reductions elsewhere,” Muoio said.
Borrowers, lenders and investors should stay focused on the potential effect of the impact rising insurance costs could have on net operating income – and make sure they understand their policies. “Insurance coverage is a promise to pay when a loss occurs,” Muoio said. “So with increasing property risk exposure, real estate investors need to read the fine print to know what is covered.”