Insurance, Not Interest Rates, Could Be the Real Threat to Multifamily

From rising interest rates to rising insurance costs it seems like hits to multifamily operations just won’t stop. Several years ago I said that certain natural disaster areas could potentially become uninsurable. Well, it seems like we are at that doorstep.

Recently, Florida and Texas, in particular, have seen the highest insurance increases across the country, oftentimes doubling premiums. The combination of basic economics with an increased risk of natural disasters has literally and figuratively created the perfect storm.

Starting at the root of the problem, it is first important to understand how insurance companies are able to stay in business. Insurance providers get paid an annual premium to protect a property from unforeseen events. Providers determine this premium by identifying both the replacement cost of the property, coupled with the risk of these events. Unfortunately over the past few years, both of these variables have been dramatically impacted. The first is witnessed by examining the impact of Covid. Specifically, Covid accelerated the expense of construction due to material chain supply issues and labor shortages, in turn dramatically increasing the replacement cost of these insured properties. The second issue is the rise in frequency of natural disasters. This is triggered by a rise in insurance claims, threatening the ability of insurance companies to stay in business.

The insurance market is replying in a way that is gravely impacting the multifamily industry. Multiple carriers are vacating these high risk areas, leaving only a handful of carriers to cover the demand. The remaining carriers are not willing to absorb additional properties as it creates a lopsided exposure within their portfolio of insured areas. Not so surprisingly, these markets are high demand markets, which means that developers have also selected these markets to bring on new supply in the next 12-24 months. If the insurance providers cannot cover the current demand, what does the future look like for these markets?

While the insurance company determine value through replacement cost, most investors determine value based on what is called the Net Operating Income, NOI, approach. Simply put, the NOI approach takes annualized Income - Operating Expenses to yield Net Income. Net Income is then divided by the market cap rate to yield the value. Insurance is an operating expense that gets factored into the evaluation. In other words, a property that is originally insured for $100,000/annually with a 50% raise in their premium in a 5 cap market equates to a $1,000,000 loss in value! While this may seem crazy, many ownership groups that I know who own properties in certain Florida and Texas markets are seeing a 100%+ increase!

If that wasn’t bad enough, there is more bad news. Lenders loan on what is called Debt Service Coverage Ratio, DSCR, which essentially assigns a ratio (assumed risk) of a property based on the net income divided by the property’s debt. Most lenders use 1.25 as a baseline ratio for the max they will lend. Loan documents also call out a minimum DSCR that a borrower needs to maintain. If a borrower fails to achieve this DSCR, the borrower may be at risk for the lender to take over the loan and force the borrower into what is called a lock box situation. In short, the lender then takes over the financials of the property, and may even take over the operations as well. With the current insurance crisis in Florida and Texas, will lenders start taking over these properties that fail to achieve the minimum DSCR?

A few other questions that remain to be answered are 1) Investors who are watching this unfold, will they steer clear of these markets due to the unregulated nature of the insurance industry? 2) Will the government recognize this potentially catastrophic risk and step in to help subsidize these areas? Or, 3) will this be the extra little push that Florida and Texas multifamily needs to fall deeply in a recession?