These “Subtle Risks” Could Have Astronomical Impacts on Real Estate Expenses w/John Sheffield

Dave:

Inflation is driving up costs and expenses across the entire economy. We all know this, but certain expenses for real estate investors seem to be growing way faster than everything else like insurance. We’ve heard that in certain states insurance has doubled in just the last year, or property taxes or repair costs. Is inflation the only culprit here or is there something else driving up costs for real estate investors Today we’ll explore an overlooked factor driving up expenses across the entire industry.

Hi everyone and welcome to the On the Market podcast. I’m your host, Dave Meyer, and today we’re talking to John Sheffield, who is the senior director in the Data and Innovation Impact Group at ice. In previous episodes, you may have heard us talk about housing market conditions with his colleague Andy Walden, and today we’re talking about climate risk and the additional costs investors could take on. As a result, we’re going to cover increases in insurance premiums, property taxes, utilities, and CapEx. And this is a super important episode because John really understands real estate investing and understands climate risk. He really puts it in easy to understand dollars and cents terms, how to think about climate risk and how it might impact what investing decisions you make in the future. So let’s bring on John. John, welcome to on the Market. Thanks for joining us today.

John:

Thank you.

Dave:

To start our conversations, there are some investors who I speak to who don’t look at climate data and think of it when they’re underwriting their properties or trying to figure out if a market is a good one for them. So can you just talk to us at the high level about what climate risk is in the context of real estate?

John:

Yeah, that’s a great question. I think I’m going to give you a little bit of a spin on this answer that may not be something you hear all the time. So when people talk about climate risk, they often think about hurricanes, floods, wildfires, big storms, discreet events that are going to impact your property cause losses, insurance claims, et cetera. We like to frame climate risk a little bit more holistically than that. Climate risk is all of the aspects of climate and climate change that are changing costs for real estate investors and the costs of land use and home ownership writ large. So think about summers are getting warmer, insulation has to be upgraded or you’re spending more money on your annual electric bills. We’ve seen winters turn very dangerous even in Texas in places that you wouldn’t predict causing huge price spikes. We’ve seen insurance costs skyrocketing in a lot of states right now. It’s been all over the news. So we think about climate risk as the full nexus of all those changes in costs and the associated property taxes and infrastructure costs and all of the other aspects of keeping real estate performing that we’re going to see climate impacting over the years.

Dave:

That is not a take I’ve heard, and I definitely am guilty of thinking of climate risk as sort of these acute impacts. And so what are some of the more common risks that occur that people often overlook?

John:

So let’s take the one that is maybe more expected just because it’s been so much in the news lately of insurance. We’ve been hearing news like Florida insurance prices in some areas have doubled every year for a couple of years. California, there are many zip codes where you can’t get an insurance policy outside of the state plan. Insurers are dropping longtime customers who have never filed a claim. So that’s one aspect of this is there is a cost of risk transfer. At the end of the day, you have a house, somebody is going to bear the risk of that house being destroyed or damaged. That may not happen every year. It may be a long tail event that you never see in a hundred years, but somebody is holding the cost of that risk. Either it’s the insurer that you’re paying premiums to or it’s the homeowner, the investor who owns the asset and should be reserving capital against that risk of loss. And as we’ve seen these risks go up, we’ve seen everyone’s estimates of the real cost of that risk go up and that’s driving up cost expectations throughout the system. So that’s one that we’ve seen in pretty common terms across the news lately.

Dave:

Yeah, because it’s interesting, I actually was looking at this map. It was sort of this heat map recently that was showing how insurance premiums had grown. I think it was by MSA by metro area, and a lot of them were in Florida, which made sense to me because you talked about hurricanes, that’s an obvious one. We see a lot in California. There are wildfires in California, but then there was ones in, I think it was in Illinois, and in my mind I had been thinking that from what I’ve read, I don’t know of any major natural disasters that happened there. So is that what’s going on here? There are sort of these more subtle risks building up that are causing these increases in insurance premiums.

John:

Let’s maybe break down the cost of home ownership and where the risks flow in here because I think Illinois is one of the most interesting case studies in the country. So your question, what are the risks that Illinois is seeing? Not hurricane, not sea level rise, no storm surge. In Illinois, we have seen a lot of growth in what are called severe convective storms. So things strong thunderstorms, maybe tornado producing storms often associated with large hail costs. So you have an interesting intersection where those costs are going up at the same time that the insurance policies, what they cover across the country can have some pretty big exclusions. So if you think about many policies exclude flood or mudslides or things like that, earthquakes, those policy exclusions mean that in areas with high flood risk, you may or may not have to purchase a separate flood policy, but that core insurance price doesn’t bake in the flood coverage In almost all of the country, a hailstorm ruining your roof is absolutely going to be covered by your primary insurance policy. And so you see these weird effects like all across the Midwest, sort of from Texas north. You see all of those risks that are covered by most policies really starting to impact premiums, especially relative to the value of the home.

Dave:

I should have seen that one coming because I lived in Colorado for 10 years where hail is a constant issue there and I have had to file claims for hail damage in the past. So it just sounds like hail is becoming more of a problem perhaps in states or areas where it wasn’t and that’s driving up insurance premiums there.

John:

Yeah, it’s the risk of the hail that’s going up. It’s the cost of replacing a roof. As we’ve seen huge inflation and labor and materials costs. We’ve seen steady growth in home prices, so the cost to replace and repair a home has gone up with that. So insurance premiums are rising from all of those distinct pressures and in different ways across the country. It affects virtually every geography but often in different ways.

Dave:

We do have to take a quick break, but what are the other major factors and costs that are impacting real estate investors? This and more after the break. Welcome back to the show. Let’s jump back in. I’m curious if you have data that is correlated with insurance premiums going up, for example, was there any way knowing what you know about climate risks to have predicted what areas we’re going to see the highest increases in insurance costs? Or are there areas where investors might be able to start forecasting where their insurance costs might go?

John:

That’s a great question. So I’m going to start actually with a fact that I find interesting and a little scary. We identified in the 2020 to 2021 range, a lot of loans that were underwritten, especially in coastal areas of Florida, Louisiana, they were underwritten at great interest rates, prime credit, jumbo loans, beachfront property, beautiful places that are going to hold up in value. So you’re seeing loan rates in the two to 3% range in many of these areas. And we were estimating from our climate data that the expected loss on those properties was higher than the mortgage interest rate. In other words, if you think about a 2% interest rate and you compare that to a 2% expected loss, you’d expect that building to be totally wiped out and rebuilt about once every 50 years. We were seeing areas that had lower mortgage costs than expected losses.

So there was this huge divergence between the two major ways that we think about risk and real estate and pricing risk. One is what is the cost on your mortgage with all of the credit and home price and other factors that go into pricing the risk of that mortgage and what is the risk of the structure staying intact? That’s what the insurance system prices, these two things had completely diverged. So we definitely think that the Florida story with burgeoning insurance costs has been building for a long time. There was climate risk that was underpriced and maybe unrecognized. We built a lot more in Florida and people have been willing to pay a lot more for prime beachfront property in Florida and basically anywhere along the coast. So you have this almost three-way effect here of climate risk is going up and we’re building more in climate risky areas and home prices had skyrocketed in those areas where we’ve now built more at higher risk levels. And so you’re seeing this insurance crisis coming about from I think all of those factors.

Dave:

That’s super interesting. Yeah, it’s almost as, or correct me if I’m wrong, but it seems that in Florida the percentage of homes, or I guess the percentage of total home value you might even say, is being put in these prime areas where people want to live, but those happen to be the riskiest. And so as insurance, the whole point is to spread the cost between many people and so more people are moving into the risky areas, and that means everyone who’s sharing those costs is going to bear that burden.

John:

Absolutely. And I think Florida is a case study. Everybody’s sort of heard about. You hear Florida hurricanes, it’s going to be risky. Let’s talk California for a second. California is interesting because the affordability crisis in California is by far the biggest story in California markets, very expensive across the state. What that’s done, you’ve seen a lot of pressure for people to move out of the big cities. So drive till you qualify as an expression that I’ve heard commute for a longer distance because you can afford housing and get a better mortgage, more affordable mortgage. Well, in that case, what we’ve seen is people moving further out of cities into an area called the Wooey. The wildland urban interface don’t trust climate scientists to come up with good acronyms. So the wooey is where you see a lot of the most pronounced fire risk. It’s where you’re right adjacent to areas that are likely to have more fire fuels. They burn hotter human caused fires from the campfires or electrical fires, things like that are more likely to impact properties when they’re built up in these areas. And that’s where in order to afford homes, a lot of the growth in California construction has been. And so we’ve been seeing a lot of growth in value in areas that are, I think paradoxically the worst for increasing wildfire risk.

Dave:

Are there any areas, John, given the data that you track that you think are likely to experience future insurance increases?

John:

So that answer is almost certainly yes. Broadly speaking, we think climate risk is underpriced across the country. Predicting insurance prices is difficult, not just because you have this uncertainty of where is the climate going, how are new regulations and plans to mitigate carbon emissions going to work as far as limiting future climate change. So you have all of those prediction problems at your hard. There’s also the problem that insurance prices are largely set at a state level by state regulators and two, I think divergent paths that we’ve seen where you see the premiums going up and where you see insurers just walking away and leaving markets uncovered or pushing homeowners onto estate plan for example. So we definitely see areas where that risk is underpriced. Broadly speaking, we think flood is one of the big risk areas where most flood risk in terms of expected loss, how much you’ll have to pay to rebuild your property in the wake of an event.

Most of that expected loss does not sit in what are designated flood zones and compel you as the buyer of the home to go buy a flood policy in order to get a conforming mortgage. Most of that flood risk is actually sitting outside of those areas. It’s often driven by things like rainfall and hurricane precipitation. Warmer air can carry more moisture and that’s why through a lot of the US Southeast, a lot of the Sunbelt that’s seen this big demographic tailwind and the big boost in home prices over the last few years, those are a lot of the areas where this type of flood risk we think has been pronounced and likely underpriced and I think underappreciated by many of the people who are buying properties in these areas.

Dave:

Interesting. Okay, great. Well, thank you for explaining that. And I do want to get back to insurance in a little bit, but from what I understand, climate risk is also impacting other expenses for real estate investors and homeowners. What are some other areas this is manifesting?

John:

Yeah, so I think everybody has kind of heard about the affordability crisis overall in home ownership. My colleague Andy Walden was on this podcast and kind of set the stage for with coupons in the 7% range for mortgages, we would need to see major changes in home values in order to bring affordability back down to historical norms. Let’s talk about this other cost of home ownership. It’s not just the mortgage, whether you’re the investor in a home or the resident of the home. In order to make that home livable, you pay insurance and property tax, you also pay for energy costs, your heating fuels your electricity, your water bill, which can be pretty variable across the country. And even within certain MSAs or even within one city, you can see very divergent costs in energy in particular. And then you also have the cost of maintenance which have been skyrocketing, especially in the wake of the pandemic.

So all of those different angles you have to pay in order to live in this home over the long term. And we’ve seen climate impacting all those. So in the energy cost space, there are a couple of interesting effects. One hotter summers, air conditioning is no longer optional in a lot of areas. Think about Washington, Washington state, which is not known for having very risky environmental disasters, right? But most of the homes in Washington state were built to code that never expected 90 degrees summers to be the norm. And we’ve seen heat waves that go over a hundred degrees for days at a time, and that level of heat is lethal in areas that are unprepared. It’s no big deal for someone in Phoenix, for someone in greater Seattle who has no air conditioning and not enough insulation total game changer for what it means to be a resident in that property through the year.

So we’re seeing a lot of those costs increasing even in areas that you don’t think of as having a lot of disaster risk. And then one more angle that I wanted to mention is to think about, we think about real estate as an ecosystem, the patch of dirt and the house that you build on it, you have to have roads and you have to have the functioning sewer system. The electric utility has to bring power lines to your home. Everyone who is bearing the cost of climate risk right now is experiencing higher costs. Saltwater intrusion is making road maintenance more expensive. Your water system and your sewer system is getting more expensive to maintain and at some point those costs are going to be passed on to the people paying utility rates or the people paying property taxes to fund those expenses. And so thinking about that whole ecosystem of where costs are increasing and how they hit the utility costs, the property taxes you pay, and then the insurance, that’s sort of where we’ve been trying to approach the climate risk story, make it a real dollars and cents problem that I think real estate investors are used to working with.

Dave:

I had never heard that take, and it sort of makes sense that if a city is as a whole experiencing higher costs that it’s going to get spread either through property tax, sales tax, some sort of tax, it’s going to get spread around. Do you have any evidence or examples of quantifying that, as you just said, where a certain city is raising property taxes because of these maintenance costs?

John:

Earlier you’d asked about Illinois, which was lighting up red for all of these kind of hidden costs of home ownerships. So let’s talk about Illinois for a second. Overall, the state has the second highest property tax costs in the nation on average, I think New Jersey is a little bit higher. Lots of people will recognize those two. As the leaders in Illinois, one of the things that you’re seeing is property taxes have been high as a percentage. They’re going up rapidly across the state just as home values appreciate. And then in a lot of areas where you’ve seen a lot of municipal borrowing to fund infrastructure investing, you’ve seen property tax receipts or property tax revenues starting to lag behind the total cost of municipal debt. And so those are areas where whether they’re raising taxes today or they have to raise taxes in the future in order to borrow more or stay fiscally healthy, we think there are some pretty significant issues there.

One of my colleagues talks about the trilemma of being an insurer, being a municipality, and I think it really applies to real estate investing as well. Three things you’ve got to do. You’ve got to stay fiscally healthy so that you can borrow attractive rates. You’ve got to be able to finance a property or your school district or your road construction fiscally healthy. You’ve got to keep rates affordable. You can’t continue hiking rent infinitely. You can’t continue hiking property taxes or utility bills infinitely. And then you also have to invest in resilience. You have to make sure you’re not deferring maintenance. There’s only so long that you can wait to put a new roof on before that becomes a bigger problem than where you started. And those three things, you can pick two, you can stay fiscally healthy, you can keep rates low, you can continue investing in maintenance and infrastructure. And we see a lot of areas where the two that they’re picking are keeping rates low and staying fiscally healthy and they’re really neglecting, I think a lot of the critical infrastructure maintenance that we think is going to be important, especially as we start talking about how the United States reacts to the risk of climate change.

Dave:

Well, thank you for sharing that example. It’s a perfect illustration of how this could start playing out. I have a similar question about maintenance costs because maintenance costs, at least in my mind, are going up for a lot of reasons. There’s tight labor market. We’ve seen supply shortages, especially during the pandemic. So how do you target or quantify the element of those maintenance increases that is related to climate risk?

John:

Last weekend, I paid a thousand dollars to fix a woodpecker hole in the side of my house. So I’m quantifying these maintenance costs in a very personal way today. So maintenance costs are tough. There are a few different ways you can estimate them. One is to look at sort of the overall replacement cost on properties, which has been going up considerably. There are a lot of jurisdictions where they’ll separate the value of your land from the value of the improvements or the structure, and you can see the replacement costs independent of the land values changing at a pretty rapid clip. We look at data sets like building permits, and we look at how often in many of these areas you’re seeing requirements to replace roofs and things like that. So who’s incurring more of these costs because you have more frequent repairs required. And I think there are a number of indices from some of the big aggregators of home maintenance of Thumbtack, Angie’s List.

You’ve probably used some of these before that have put out studies where they’re watching significant inflation in some of those costs. So not all of that is related to climate change. You pointed out pandemic and supply shocks and general wage inflation over the last few years. We don’t think climate change drives every risk. What we think is that climate change is an accelerator of a lot of those risks. So you have a requirement for more investment in insulation, fixing your roof more often because of storms that may or may not be insurable in the damage they cause. All of those things are happening at the same time that you have this inflation in maintenance costs at the same time that you have dynamics increasing property taxes and utility costs. It’s really that nexus or the feedback loop of all these things happening simultaneously that makes climate change and accelerator.

Dave:

We do have to take one more break to hear a word from our sponsors, but when we get back, we have more with John Sheffield. Stay with us while we’re away. Make sure to hit that follow button so you never miss an episode of On the Market. Welcome back to On the Market podcast, everything you’ve said so far, John makes sense to me in a logical, intuitive way. I’m curious though if you have any examples or advice on how investors can use what you’re telling us here for their own investing decisions.

John:

Yeah, that’s a great question. So one baseline point is just to be aware of the risk, to understand the fine print of what is in your insurance policy, what’s covered, what’s not covered, and to think about those two things simultaneously. So if you know you’re in an area with significant flood risk, whether that risk is in a flood zone or not, it’s important to know that many insurance policies will not cover you for the impact of those floods. So I think there’s a very basic awareness layer that needs to happen. There are a lot of great tools out there for consumers, for small investors and large. We build a property level climate risk dataset that covers, I think a bit over 110 million rooftops in the US and there are a lot of people working in this area to just promote better transparency around where this risk is.

The other piece is when you’re thinking about underwriting a property, seeing a fit, pencils at home, prices that are still near all time highs, think about all of the costs, not just the cost of the financing, the sticker price on the property. Think about where taxes are today and the likelihood that those taxes escalate with all of these different impacts coming in. Think about your insurance costs and whether you’re in areas that haven’t seen the same level of growth that maybe Florida has, is that growth coming for you next year? So think about those scenarios where we’ve been seeing this story play out across the country in different ways and make sure, I think a lot of our take on climate risk. Make sure you have a little more of a cushion margin for error in the way you’re thinking about property pricing right now.

Dave:

Is that meaning John, that you think we’ll see property places decline in places that have this higher climate risk?

John:

There are a number of academic studies that are already showing this. I think one of the best in methodology and one of the largest effects, they called it climate gentrification in Miami. Miami’s been a good market. Property prices has been going up, but areas with higher risk, even within the Miami market have been seeing home price appreciation lags well behind areas that are at lower risk. A couple feet of elevation makes a big difference in many of these areas. We think those mechanisms are pretty varied. Buyers are becoming more aware. You can now see climate risk on many of the major real estate listing sites. We think that insurance costs are definitely starting to put a dent in affordability in areas like Florida. Some of our research has shown in Miami across the metro, 85% of the mortgage is what you can expect to pay in terms of property tax and insurance cost and energy bills. It’s almost a whole second mortgage payment in terms of the average annual cost of those line items.

Dave:

Whoa. So wait, just so I understand. Normally a mortgage is broken down into a couple different things. We would call it p and i principle and interest is the main thing. Sometimes in mortgages it’s also included in escrow as your insurance and taxes. But if those things out, you’re saying the principal and interest, and then in terms of taxes, insurance, they’re almost as much as principal and interest.

John:

So we looked at about $5.6 trillion of mortgages that were from a lot of different vintages outstanding in February this year. And you’re right, principal and interest cost and then the tax insurance energy bill line items that are other big costs of homeownership that have the risk of climate shocks and other inflationary pressures. And in Miami, 85% of your mortgage cost is the value of those climate affected cost lines and where that connects to home prices, I think in two ways. One is those costs are high and a lot of the demographic boom that we’ve been seeing in the Sunbelt states, lots of people moving for low state taxes when they get there and they find, oh, actually my low state tax bill also comes with a $6,000 annual insurance cost and significant electric bills and property taxes that are going up. I think a lot of those tax savings are eaten away.

So a lot of the tailwinds that these markets have been experiencing from lower costs, that’s starting to change and I think people are becoming very aware of it as they think about whether Florida is really the long-term retirement spot. So that’s one big aspect of this is there are fewer buyers piling in to markets where these costs are becoming more pronounced. The second is that I think everyone, the big narrative on home prices has been, yes, interest rates are high, but everyone’s sitting on a mortgage from 2020 and 2021, they’re mostly fixed rate. They don’t have to go anywhere. Their payments are low. You can still see shocks, the payment shocks from taxes going up, insurance costs, energy bills, all these other required costs of homeownership. Those are escalating and where you see nasty surprises in the cost of homeownership, even when you have a fixed rate mortgage, I think we’re likely to see in some of these markets where we have the most inflation in these other costs. One of the best lines I’ve ever heard about mortgages, rent is just an adjustable rate mortgage with zero disclosures. What we’re seeing with a lot of these excess costs of homeownership, we’re seeing fixed rate mortgages that have this big adjustable rate component with no disclosures. And that’s something that as buyers have greater awareness, we think this narrative is a little bit more complicated than everyone with a 2021 loan can stay in place.

Dave:

That is fascinating. And in the past, I’ve definitely been guilty years ago saying one of the great benefits of real estate investing is you get a fixed rate mortgage and your costs stay relatively similar. Your principle and interest don’t change if you have fixed rate mortgage. So that part is, but now in this new era to John’s point, these other costs are changing and can really drive up your expenses in a way that, at least in my investing career, we haven’t seen. And that is definitely something to think about and it’s at least I’ve found it in the past, hard to predict where taxes are going to go up, where insurance is going to go up. So that actually brings me to my last question for you here, John, is where can investors get this data? Is there a place where they can look at this and try and make sense of their own portfolio as it exists currently and use it for trying to be more accurate in underwriting future deals?

John:

Yeah, that’s a great question. So I’m going to start by plugging my colleague, Annie Walden and others at Ice run a monthly mortgage monitor report where we’ll be pushing a lot of this data and publishing research as quickly as we can mine the numbers. So I think there’s a broad interest at every level of the investor base that we speak to from small single family investors to commercial private equity all the way up to many billion dollar asset managers. Everyone is interested in climate data right now, and we’re publishing research on this around the clock. I think the big picture for where to go get data and how to think about it, look for physical climate risk, things like property level scores might be easy to interpret or if you can get actual expectations of loss because that’s what your insurer is going to be looking at when they’re pricing your premiums in three years. And then also try to get a better understanding of some of these tax and energy costs bills. We’re publishing data on this and summary reports to try to bring some transparency to those markets.

Dave:

Got it. Well, thank you so much, John. I appreciate you sharing your knowledge with us. I learned a lot from this conversation. If anyone wants to learn more about John and what his team is putting out some of the reports that he just mentioned, we’ll make sure to put links to all of that in the description below. John, thank you so much again for joining us for this episode of On The Market.

John:

My pleasure. Thank you.

Dave:

On The Market was created by me, Dave Meyer and Kailyn Bennett. The show is produced by Kaylin Bennett, with editing by Exodus Media. Copywriting is by Calico content and we want to extend a big thank you to everyone at BiggerPockets for making this show possible.