Real estate has become an increasingly popular choice among investors of almost every category. Whether you’re a large investor buying whole properties or a retail investor buying into REITs or ETFs, this asset class can be a smart choice for your portfolio. But, according to a recent publication from Origin Investments, there is one risk you need to be aware of: the weather.
Consider working with a financial advisor when adjusting your investment portfolio for changing factors.
“Multifamily investors face an unprecedented challenge from rising commercial property insurance rates due to weather-related losses and rising construction costs, among other factors,” Origin Investments said. “Respondents to the National Multifamily Housing Council’s 2023 State of Multifamily Risk Survey note that insurance costs are increasing an average of 26% year over year. We identify even greater premium increases in the target markets that make up our multi-family investments. »
Here’s what happens.
Real estate is a profit-based investment
When you invest in real estate, particularly through a REIT, you are typically investing in the operation and management of a portfolio. In other words, the fund owns properties such as residential apartments and commercial leases, and the profits generated by these companies constitute the returns of the portfolio.
Likewise, when you buy a property, you earn money directly from its profits. Although often reserved for large or institutional investors, many households own rental properties such as apartments or Airbnbs.
Either way, the company’s profits are based on both its revenue (usually the rent you can charge for a given space) and its costs. Rising costs are eating away at that performance, and that’s where Origin’s warning comes in. The real estate market is starting to get more expensive, and that’s bad for investors.
Weather events lead to higher costs
The problem is property insurance. As Origin notes in its article, global insurance premiums rose 4% in the first quarter of 2023. This was, they write, “the 22nd consecutive quarter of composite rate increases; quarterly increases peaked at 22% in Q4 2020.”
It’s even worse for homeowners in the United States, where rates rose 17% in the first quarter of 2023.
Those are big numbers but, if anything, they underestimate the problem. According to the Federal Reserve, premiums have skyrocketed to the point that it costs about twice as much to insure a property today compared to this time in 2003. These premiums are making it more and more expensive to operate the same property every year. This means lower profits which, in turn, mean lower returns on a portfolio.
Behind all this there is a change of weather.
As weather events become more extreme, high value insurance claims have become more common. Factors such as heat, wind and extreme cold are causing more damage than before, forcing homeowners to file claims for issues ranging from damaged pipes to structural support. At the same time, catastrophic events like fires and floods began to drive more total loss claims, creating an increase in maximum value claims against property insurance.
As Origin notes, in the past five years alone, weather-related insurance losses have increased by 162%. For investors and owners, this has created three huge new cost centers.
First, as noted, premiums have increased. To cover their increased payouts, insurance companies raised the price of insurance.
Second, many insurers have started to reduce the coverage itself. Whether it’s changing the way they calculate damages or simply eliminating areas of coverage, many insurance companies have begun to modify their policies in response to changing risks. This forces homeowners to seek specialist insurance or face the full costs of a natural disaster.
Finally, even with insurance, a claim always costs money. Damage can result in lost revenue, high soft costs and even reputational damage that reduces the long-term value of a property.
What can investors do?
It will be difficult for investors to completely protect themselves from this problem. To some extent, the market will resolve itself as landlords fix their new costs in leases and other contracts. However, this is only a partial solution. New insurance costs and claims events are too high to be fully passed on to customers.
For investors who own property directly, Origin advises taking steps to further insulate your business from a potentially volatile insurance market. Negotiate insurance rates as far in advance as possible and possibly create different models for standard liability issues (such as slip and fall) versus catastrophic loss scenarios (such as fire or flood). At the same time, look to buy or retrofit buildings around next-generation infrastructure such as fire-resistant materials and flood mitigation technologies. Although these steps increase initial costs, they will generally save money over the life of your investment.
Investors who have invested in funds, meanwhile, should look for these approaches in their portfolio. Invest in funds that have themselves pursued effective loss mitigation strategies. If possible, ask how the fund has protected itself against insurance and weather-related issues. Pay particular attention to the markets in which a fund operates. Although no region is immune to climate change, some markets are more exposed than others. If a fund owns real estate in particularly risky locations like California, Texas, or Florida, among others, ask what steps it has taken to manage those risks.
Conclusion
Insurance and loss costs increase. For investors, that means taking extra steps to protect yourself and your money. A recent report from Origin Investments highlights an emerging risk for real estate investors. As weather conditions become more extreme, insurance costs and losses from floods and other destructive weather events increase, which could eat into your bottom line.
Tips for investing in real estate
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A financial advisor can help you explore how to incorporate real estate investing into your financial plan. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three approved financial advisors who serve your area, and you can have a free introductory call with your advisor to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
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Real estate can still be a great investment for your portfolio. Investors looking to add higher growth assets (while understanding that high growth can mean higher risk) can consider this burgeoning area.
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