The real estate market is governed by certain assumptions, one being that mortgage financing is always available to qualified borrowers. The catch is that you can’t get a mortgage without proper insurance, and insurance may become both more costly and less available as insurance companies and government regulators begin to re-think the new world of climate change.
The new focus on insurance and climate is a looming problem for real estate investors as well as property owners in general. The immediate issue is rising cost but lurking in the background are new and tougher standards to get coverage in the first place plus potential mortgage contract violations when coverage is canceled or declined.
The result is that locations which are beautiful and alluring 51 weeks a year may be increasingly difficult to finance and refinance. When the time comes to sell, tougher insurance standards may effectively limit sales to cash buyers who can avoid the need for mortgage financing. Condo coverage – especially for older properties – may require both higher premiums as well as major repairs that result in huge special assessments. Long-term investor strategies to rent today and retire tomorrow may be challenged by burning fires and rising waters.
Let’s start with FSOC. That’s the Financial Stability Oversight Council, a little-known part of the Treasury Department and now the author of a just-released climate report.
“For the first time,” said Treasury in late October, “FSOC has identified climate change as an emerging and increasing threat to U.S. financial stability.”
It’s a shot across the bow. Read this and ask if you really want to be the bank that has to explain to regulators why you have a portfolio of mortgages that are literally underwater or up in smoke.
“It does not require a vivid imagination to see how climate change could threaten the financial system,” said Treasury Secretary Janet Yellen. “As climate change intensifies, more frequent and severe climate-related events – wildfires, tropical storms, and flooding, for example –could trigger declines in asset values and economic activity that could cascade through the financial system, especially if such risks are not properly measured and mitigated.
It’s not just the government that’s noticed a change in the weather. So have insurers. For instance, after Hurricane Sally hit Florida’s Gulf Coast in 2020, three Florida insurance companies left the state and 53,000 homeowner policies were canceled or not renewed, according to The Miami Herald.
On the West Coast, the Insurance Journal estimates that in drought-stricken California, where vast wildfires have consumed hundreds of thousands of acres, “as many as 2.4 million homes are at risk of losing protection in 2021.” The Congressional Research Service says that across the country 10.1 million acres burned in 2020.
When policies are canceled, property owners with mortgage financing — whether real estate investors or owner-occupants — must find replacement coverage. Such coverage is not an option, it’s required by mortgage contracts.
If owners don’t get or can’t get replacement coverage then, according to the state of New York, “lenders can step-in with “force-placed insurance, also known as creditor-placed, lender-placed or collateral protection insurance is an insurance policy placed by a lender, bank, or loan servicer on a home when the property owners’ own insurance is canceled, has lapsed or is deemed insufficient and the borrower does not secure a replacement policy.”
“A lender,” adds the state, “may also force-place flood insurance on homes in flood zones that they believe do not have enough flood insurance to meet the legal minimum required to protect the property.”
Ultimately, lenders can foreclose if property insurance is inadequate or unpaid.
As insurance companies leave the market, those who remain increasingly constitute an oligopoly, an arrangement with few sellers, many buyers, and – because of limited competition – a ready ability to increase prices.
The National Flood Insurance Program (NFIP)
There are problems whether an owner gets new coverage from the private-sector market, a state, or a federal program. Replacement rates can be much higher than existing policies, while state programs may not offer equal coverage.
One possible backstop is the National Flood Insurance Program (NFIP), a federal plan designed to protect homeowners in areas with known flood risks. Sounds like a great idea, but premiums have not kept up with pay-outs and the program — by normal measures — would be bankrupt had not Congress canceled $16 billion in NFIP debt to the Treasury in 2017.
Today the NFIP owes more than $20 billion to Uncle Sam and has embarked on a plan — Risk Rating 2.0 — to increase premiums and become solvent. The hook is that premiums can increase as much as 18% annually. A $1,500 policy today could cost $7,850 in 10 years.
“The real question is how to pay for the new premiums,” said Rick Sharga, Executive Vice President with RealtyTrac. “For someone on a fixed-income, or for an investor looking for a solid return on rental income, an 18% annual increase may be unaffordable and even a reason to sell.”
The bigger problem
The FSOC report points out that “insurers of property, hazard, flood, and other property-related risks are directly exposed to these risks. To reduce their potential losses, insurers may seek to increase premiums or withdraw from at-risk markets, which may lead to reduced affordability or availability of insurance coverage in vulnerable regions of the country.
“Such responses by insurers,” said FSOC, “may affect the economic and financial health of households, businesses, and governments in these communities. In addition, increased actual damages to properties associated with physical risks may lower the value of collateral or the income generated by such properties, posing credit and market risks to banks, insurers, pension plans, and others.”
Translated into plain language, FSOC is saying that lenders need to be tougher when financing real estate in areas with increasingly-obvious environmental challenges. Think of lender demands for more insurance coverage, bigger down payments, stronger building codes, and better community planning.
What happens if more insurance companies pull back, if coverage in flood- and fire-prone areas is not available at any price?
There will have to be some version of affordable NFIP and state programs. Without acceptable insurance coverage, real estate worth more than $1.3 trillion dollars — the properties now covered in 22,000 communities through the NFIP — will be thoroughly devalued. That’s not politically or economically tolerable.
At the same time, look for far-tougher building codes in areas threatened by floods and fires as well as more frequent “managed retreats,” neighborhoods where state or federal governments buy up vulnerable properties when they become available to assure they’re never again developed.
Check and re-check
Climate change is redefining which homes will be impacted and which will not. Information – including “official” information – may not be current or accurate. In 2016, as an example, National Public Radio (NPR) reported that federal flood maps for New Orleans had been revised.
“The new maps are like a bureaucratic magic trick,” said NPR. “At the stroke of midnight, the federal government waved its wand, and Friday morning more than half of New Orleans woke up in a land safe from storms and flooding.”
In reality, much of the city remained below sea level – and sea levels are rising. Check with state and local governments for likely fire- and flood-prone areas, and speak with local insurance agents, real estate brokers, and emergency preparedness officials for specific information and advice.