Real estate has become an increasingly popular choice among investors of just about all classes. Whether you’re a large investor purchasing entire properties, or a retail investor buying into REITs or ETFs, this asset class can be a strong choice for your portfolio. But, according to a recent publication from Origin Investments, there’s a risk that you should be aware of: weather.
Consider working with a financial advisor as you adjust your investment portfolio for changes factors.
“Multifamily investors are facing an unprecedented challenge of 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 insurance costs surging an average of 26% year over year. We are identifying even higher premium increases in the target markets that comprise our multifamily investments.”
Here’s what’s going on.
Real Estate Is a Profit-Based Investment
When you invest in real estate, particularly through something like an REIT, you typically invest in the operation and management of a portfolio. That is, the fund owns properties like residential apartments and commercial leases, and the profits generated by those businesses make up the portfolio’s returns.
Similarly, when you buy a property outright, you make money directly off its profits. While this is often reserved for large or institutional investors, many households own rental properties such as apartments or Airbnbs.
In all cases, the profits of the business are based on both its revenue (typically how much rent you can charge for a given space) against its costs. Rising costs eat into this 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. It was, they write, “the 22nd consecutive quarter of composite rate increases; quarterly increases peaked at 22% in the 4Q 2020.”
It gets even worse for property owners in the U.S., where rates increased by 17% in the first quarter of 2023.
These are large numbers but, if anything, they understate the issue. According to the Federal Reserve, premiums have soared to the point where it costs around twice as much to insure a property today compared with this time in 2003. These premiums make it more and more expensive to operate the same property each year. That means lower profits which, in turn, means reduced returns on a portfolio.
Behind all of this is a change in the weather.
As weather events grow more extreme, high-value insurance claims have become more common. Factors like heat, wind and extreme cold cause more damage than they once did, forcing property owners to file claims on issues from damaged pipes to structural support. At the same time, catastrophic events like fire and flood have begun to cause more total-loss claims, creating a surge in maximum-value claims against property insurance.
As Origin notes, over the past five years alone, weather-related insurance losses have increased by 162%. For investors and property owners, this has created three enormous new cost centers.
First, as noted, premiums have gone up. To cover their increased payouts, insurance companies have raised the price of insurance.
Second, many insurers have begun pulling back on coverage itself. From changing how they calculate damages to simply eliminating areas of coverage, many insurance companies have begun to alter their policies in response to changing risks. This forces property owners to seek specialty insurance or face exposure to the entire costs of a natural disaster.
Finally, even with insurance, a loss event still costs money. Damage can lead to lost revenue, high incidental costs and even reputational harm that reduces the long-term value of a property.
What Can Investors Do?
It will be difficult for investors to entirely protect themselves from this issue. To a certain degree, the market will self-resolve as property owners price their new costs into leases and other contracts. However this is only a partial solution. The new costs of insurance and loss-related events are too high to entirely pass along 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 potentially create different models for standard liability issues (such as slip-and-fall) vs. catastrophic loss scenarios (such as fire or flood). At the same time, look to buy or upgrade buildings around next-generation infrastructure such as fire-resistant materials and flood mitigation technology. While these steps increase up-front costs, they will typically save money over the lifetime 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. When possible, ask about how the fund has protected itself from insurance and weather-related issues. Pay particular attention to the markets that a fund operates in. While no area is insulated from changing weather patterns, some markets are more exposed than others. If a fund owns real estate in particularly exposed places like California, Texas or Florida, among others, ask what steps it has taken to manage these risks.
Bottom Line
The costs of insurance and loss are rising. For investors, it means taking extra steps to protect yourself and your money. A recent report by Origin Investments highlights an emerging risk for real estate investors. As weather gets more extreme, the costs of insurance and losses from floods and other destructive weather events are rising, and that could take a bite out of your profits.
Tips on Investing in Real Estate
- A financial advisor can help you explore how to integrate real estate investing into your financial plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Real estate can still be a great investment for your portfolio. Investors looking to add some higher growth assets (while understanding that high growth can mean higher risk) may want to consider this booming field.
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