Real Estate Investors Continue To Roll Dice On Disaster-Prone Assets

It was 11 p.m. on a Friday when Hurricane Harvey made landfall in Texas. Anxious investors watched as record rainfall flooded Houston businesses, and tens of thousands of people fled their homes in boats.

When the rain stopped, investors started calling Caldwell Cos. President and CEO Fred Caldwell, whose company invests, manages, brokers and develops residential and commercial real estate throughout the Greater Houston area.

“Immediately after, everyone was very concerned,” Caldwell said. “They were concerned about properties and appropriately so given the media attention to the largest rainfall event in U.S. history.”

Despite the initial stress and $125B in damages by the storm, Caldwell’s investor clients have not changed their appetites for Houston, and continue to invest in Southeast Texas.

Last year was the costliest on record, with 219 weather disasters causing $1.5 trillion in damages, according to the National Centers for Environmental Information. Sixteen weather events exceeded $1B in damages, tying 2011 for the record in billion-dollar disasters.

Despite these record-breaking numbers, investors continue to place bets on real estate, because so far, property’s profitability has been worth it. But as the damage toll goes up, the safety net of insurance may be pulled back, and CRE may no longer be worth the risk.

“If you think that insurance is always going to cover you, you have to recognize insurance changes every year,” Urban Land Institute Executive Director for Center of Sustainability and Economic Performance Billy Grayson said. “When thinking about insurance rates and overall costs of running a building, it’s going to change a lot in the next 50 years.”

The cost of damages will keep going up for sought-after coastal properties. In the next 15 years, higher sea levels, along with storm surge, will increase the cost of coastal storms from $1.5B to $3.5B, according to a Risky Business report. Add this to the increased severity of hurricanes, and the annual price tag for damages is expected to reach $35B each year.

“Increasingly, investors need to do due diligence on concurrent environmental problems and climate change threats to real estate they are using or buying or developing,” said Celeste Hammond, professor of law and director of the Center for Real Estate Law at The John Marshall Law School. “It’s a whole new world.”

When An Investor Decides To Leave

Natural disasters are a part of the considerations of long-term investor STRS Ohio. The pension fund no longer invests in Florida because insurance premiums jumped considerably after Hurricane Andrew in 1994, according to STRS Ohio Acquisition Director Eric Newberg. Ongoing flooding risks also contributed to the decision.

Following Hurricane Irma, which cost about $50B in damages, a handful of other investors have started to reassess property in Florida. A large real estate fund that only owns multifamily said it just does not see the numbers working in Florida, according to Arthur J. Gallagher Area Vice Chairman and Managing Director Alexandra Glickman. The investor was turned off by insurance costs and high operating expenses, including maintaining properties in an area that is high risk for flood and mold, she said.

Glickman’s commercial insurance clients are starting to consider a slowdown on acquisitions in South Florida, she said, especially if the operating margins are so tight that the deal is one basis point away from being profitable or unprofitable.

Franklin Street Director of Multifamily Investment Sales Hernando Perez previously told Bisnow that several investors initiated conversations to pull out of South Florida following Irma. He said these clients were new to the market and had yet to experience a strong hurricane. Instead of going through the patching and rebuilding process, these clients wanted to switch to assets that require less responsibility and were in areas that were not as vulnerable to storms and shifts in the market.

Since STRS Ohio tends to hold properties for 20 to 30 years, it takes a long-term view of its assets, which could be greatly impacted by natural disasters, and has been taking closer looks at potential risks and mitigation efforts.

A year and a half before the fires that devastated the Fountaingrove neighborhood in Santa Rosa, California, STRS sold a multifamily asset consisting of two Fountaingrove properties that later sustained significant damage during the fires. Newberg said while his company typically carries fire insurance, the recent wildfires have made the company stop and think about what is around an asset that could cause problems.

While natural disasters did not motivate its sale in Santa Rosa, the pension fund did sell an office property in downtown San Francisco in part because of the potential for a large earthquake in the Bay Area. The investor felt it was overallocated in office, with three office properties close together totaling $1B, and the fund needed to diversify. If there was a major seismic event, the fund could possibly go past its earthquake coverage and suffer a great loss, according to Newberg.

“It just created an insurance risk we weren’t willing to accept,” he said.

While rising sea levels are not a deciding factor to whether or not it will acquire assets along the West Coast, STRS Ohio is considering its impact more than it did five years ago, Newberg said.

“Every year, the average temperature increases across the world,” Newberg said. “You have to start paying attention to that when looking at real estate and making sure cities are addressing it or addressing assets correctly, or just decide not to invest in certain markets.”

How climate change will impact CRE decades from now can be a tricky topic for investors, owners and capital markets, according to ULI’s Grayson. Pension fund managers might pay closer attention to insurance rates and overall risks from natural disasters because they typically hold assets for decades, but a developer might own a property from two to 10 years and not experience a major disaster during that time.

“It’s tough to predict the future, but it’s hard to imagine a future where there isn’t more attention to long-term impacts of climate change and integrating them more effectively into CRE investment and development,” Grayson said.

Short Memories, High Growth: Why Investors Aren’t Slowing Down

Even though 97% of public REITs identified natural disasters as a business concern in a recent report from accounting and consultant firm BDO, none have left a specific area due to a disaster, according to BDO partner and national leader of real estate and construction practice Stuart Eisenberg.

While some of the coastal hotels in hurricane-prone areas last year reported losses, they had property and business interruption insurance and were able to recoup the losses, according to Eisenberg, who assists real estate and hospitality clients with financial reporting and accounting. His Houston clients were not negatively impacted, either, and the time it took to get back online was faster than expected, he said.

Even hotels next to damaged properties benefited from increased occupancy, he said. The long-term benefits of being in popular areas is worth the deductibles paid out after a disaster, he said. His clients go into these markets well aware of the potential risks.

“It all comes down to the investor looking at that market and seeing if they can address those risks,” he said.

A place would have to be completely destroyed and uninhabitable for investors to consider leaving a location, Eisenberg said. The pull to have a piece of profitable real estate remains strong and many soon forget the destruction storms can cause.

“History has shown that we really have short memories,” XL Catlin President of Property and Engineering Michele Sansone said. “There will be a few that get fed up and want to stay out of those markets. Others will see it as an opportunity to pick up on some reasonably priced real estate.”

Even after Harvey, Houston is still seen as a great place to do business, Caldwell said. The area has a low cost of living, low income tax, great weather for most of the year and is one of the most diverse cities in the country, he said.

While Harvey inflicted massive damage to residential properties, commercial did not get hit hard. Commercial properties were impacted the most in the Energy Corridor on Houston’s west side, according to Caldwell. Some corporations could decide to move into different submarkets that have a lower probability of flooding. 

“The reality is Houston fared, in my mind, pretty well,” he said. “Houston is somewhat accustomed to large rainfalls.”

Houston’s real estate market is doing well post-Harvey. Less than 7% of Houston’s office supply was impacted by the hurricane, and a majority has already been repaired and is back online, according to a report from Colliers International.

Investment sales grew 54% in Q4 2017 compared to Q4 2016 with signs the energy industry is on the rebound. Average sales price rose to $245/SF from $199/SF quarter over quarter. While vacancy rates increased to 19.1% for Class-A office last quarter compared to 17.5% in Q4 2016, positive net absorption was recorded for the first time in six quarters.

Home sales and demand for homes in Houston remain strong and people are not leaving the state, Caldwell said.

U-Haul’s most recent data ranked Texas as the top state for arrivals, accounting for over half of U-Haul’s one-way traffic. Year-over-year arrivals increased 1% while departures increased 3%, due in part to the hurricane. Florida had the second-highest growth for one-way arrivals.

A similar story is playing out in the Pacific Northwest, which is primed for a major earthquake. Washington had the sixth-most one-way arrivals in 2017, the highest of any West Coast state, according to U-Haul. Seattle added 220,000 jobs in the last decade, an increase of 15%.

Market dynamics have strengthened in Seattle in the past five to six years due to Silicon Valley companies setting up secondary offices and foreign investors flooding into the city, according to American Life Inc. CEO Henry Liebman.

American Life works with foreign investors through EB-5, and Liebman said he has seen no indication of any shift in attitudes toward CRE investment in the U.S. because of the recent spate of disasters.

The Puget Sound fault could create a monster of an earthquake and a tidal wave, but investors buy earthquake insurance and hope for the best, he said.

“Seattle is booming right now,” Liebman said. “There can’t be a lot of people who are staying away.”

Insurance Won’t Be Able To Keep Saving The Day

Insurance has long been seen as a fail-safe to help keep investments profitable after a disaster, but the costs are piling up and insurance companies are raising rates. Combined with earthquakes in Mexico, hurricanes Harvey, Irma and Maria and the fires in Northern California, global insured losses from catastrophes were roughly $134B as of early January. The Northern California fires alone amounted to $9B, according to Arthur J. Gallagher Senior Vice President Martha Bane.

Lloyd’s of London, which often insures risks no one else will, took an initial $4.5B in losses from Harvey and Irma. Insured losses could have been higher, but most of the property in Houston that was damaged or destroyed by the flood did not carry flood insurance.

Even with such high losses, insurance carriers have yet to indicate a wholesale shift from offering insurance in flood- and storm-prone regions. Top insurance carrier AIG, which reported a record-high $4.2B in catastrophe losses for the year after being hit by Harvey and the California wildfires, reported $3.2B in adjusted pretax income.

Changes to the tax code had a major part in improving insurers’ profits. Even with combined loss ratios above 100%, carriers got lifts from reduced tax obligations, AJG's Glickman said. Combined loss ratios are used to measure insurer profitability and anything over 100% indicates significant losses. Reduced tax obligations could be helpful long term since it would improve the bottom line and boost margins, according to Yahoo Finance.

Industrywide, traditional and alternative capital, which are funds typically backed by investors and activated when a specific catastrophe hits, absorbed a significant portion of the losses, according to a report from Swiss Re.

But now insurers will not have the cushion of alternative capital for subsequent loss years, so rates will rise for reinsurance and insurance.

Some carriers initially declared 20% rate increases across the board after the hurricanes, and many others are reassessing their insurance structures and approach going forward, according to Glickman. AIG reported single-digit rate increases during each of the months in Q4, which has been sustained into Q1.

Regular property commercial offices in areas like Wisconsin where there were not disasters will see 0% to 5% rate changes, Bane said. California is expected to have high-single-digit increases, while Florida might have 10% to 11% increases.

“Almost all CRE will be a bit more, regardless of where you are,” Bane said.

The cost of insurance can impact the types of assets pensions funds will buy, according to STRS Ohio’s Newberg. If earthquake insurance is too high, it may preclude a pension fund from purchasing a specific asset, often involving multifamily, which is usually the costliest asset. STRS Ohio has instead been partnering with more developers, which typically carry the often-expensive earthquake insurance.

When insurers start leaving markets altogether, it will reduce choices and may make it so that property owners cannot get coverage for some properties, ULI’s Grayson said.

Instead of insurance companies refusing to cover an asset or area, these companies should better incentivize property owners when they retrofit or build more resilient buildings, according to Grayson.

Such was the case at 181 Fremont in San Francisco. Structural engineer Arup added a shock absorption system to help it withstand a major earthquake. The building’s owner, Jay Paul Co., is working on receiving more favorable policy terms from its insurer after it made investments in resiliency, according to Grayson. The building's resiliency also helped attract tenants and residents, he said. 

More due diligence may be needed for locations to assess flooding risk and to make sure adequate insurance is in place. Investors will need to further assess how a property can withstand physical damage and whether the property and the operators have adequate backup systems to manage through a crisis based on recent experience, according to RCLCO Director of Asset Management Jomar Ereso.

RCLCO will advise clients to consider all risk mitigants, such as reviewing building design and disaster recovery planning and insurance, when considering the impact of natural disasters as part of a full property assessment, Ereso said.

“Institutional investors are increasingly asking the question and evaluating their potential exposures to climate-change-related impacts,” Ereso said. “But from our perspective, [they] are primarily focused on this issue at the asset level: does the property under diligence or review sit in a 100- or 500-year flood plain? Are the risks insurable?”

A Future Flooded With Risk

Scientists have said we are past the point of no return to avoid increased natural disasters related to climate change, according to Hammond. Her team at the The John Marshall Law School Center for Real Estate Law has been researching the impact of natural disasters on CRE while also teaching transactional attorneys how best to advise clients on the risks.

Part of the problem is explaining to people about the real risks. People hear about a 100-year or 1,000-year flood and assume that it will not happen again for a long time, but these floods are starting to occur much more frequently, she said. These statistics only explain the risk and magnitude of the floods.

She said 50% of the U.S. population still lives within 50 miles of a coastline. Residents of heavily populated areas like New York City, Boston, South Florida and other coastal areas have significant flooding risks.

“I keep wondering how many disasters do we have to see before we think about it,” Hammond said. “It is really a serious problem.”

CORRECTION, MARCH 19, 1:15 P.M. PT: A previous article incorrectly stated Jay Paul Co. achieving favorable policy terms and Facebook's reasons for renting space at its 181 Fremont building. The article has been updated.