Unexpected Ways Climate Change Affects Commercial Real Estate

It is certain that climate change impacts commercial real estate in coastal areas; however, the details about the impacts are not obvious. Barron’s reported that Morgan Stanley recently reminded everyone that investors hold about $56 billion in potentially risky commercial-mortgage-backed securities (CMBS).

The collateral for these potentially risky CMBS are mortgages on commercial real estate that is located in coastal zones. The logical thought is since coastal zones are potentially subject to flooding caused by climate change, then there is an increased risk of default on mortgages for these particular CMBS.

Actions Already Taken By Risk-Adverse Institutional Investors

The logic is reasonable. There may be an increased risk of flooding in coastal zones. However, the counter-intuitive concept, which surprises many, is that institutional investors have already taken steps to mitigate this risk. These investors do not just sit there with an investment portfolio that has an obvious and large potential risk exposure without doing something about it.

Institutional investors already require commercial landlords in these coastal areas to carry full flood insurance. This requirement is for properties in flood zones and extends to new areas that are potentially at risk of flooding. For commercial properties, the requirement for flood insurance extends to areas that are not in historical flood zones since the maps are outdated.

A lack of flood insurance is much more problematic for residential properties than commercial properties. Residential lenders may still rely on the old flood zone maps to their detriment.

For commercial properties, loan underwriters made the insurance requirements for these areas more rigorous a long time ago. Moreover, the real risk of loan defaults by commercial landlords may be less than suspected based on recent disaster experiences.

Lessons Learned From Actual Disasters

After Hurricane Katrina hit the New Orleans area in 2005, there as a problem with significant flood damage, which was not covered by insurance. When Hurricane Harvey caused serious flood damage to the Houston area in 2017, investors feared a repeat of the Hurricane Katrina experience.

In reality, after Hurricane Harvey, Houston businesses only had a slightly more difficult time paying their mortgages. The default rate rose from 1.7% in July 2017 to 2.5% in 2018. This compared favorably with the nationwide delinquency rate for the entire CMBS market of 4.4% in 2018.

Some Houston businesses also got surprising revenues boosts such as hotels and apartments that provided temporary housing for displaced residents. Certain retail stores and wholesale suppliers also did well by providing the materials needed for the rebuilding efforts.

Conclusion

The risk of default by commercial landlords on mortgages in coastal areas may be less than feared if insurance is in place that covers the risks. Commercial landlords are forced to have more insurance coverage in these areas. They will pay higher insurance premiums than before and the premiums may increase substantially.

The expected cost of increased insurance premiums has already been taken into account by many commercial businesses operating in these areas. The businesses have an easier time paying increased premiums than individual homeowners since they have greater access to capital.

This analysis shows that institutional lenders changed lending practices in order to manage the risks of the flooding events that are expected to occur. However, homeowners in these coastal areas are more likely not to be insured adequately for flood risk. They may rely on inaccurate flood maps and therefore are not well-prepared for the impact of climate change.

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