We predict these loan documents will soon be more detailed in their requirements for commercial properties located in coastal, highly populated areas that have or are likely to have high flooding risks. Many factors are converging on this tipping point including:
- the strengthening climate change populist movement around the world
- the increasing velocity of climate change reports and studies published by the United Nations, the World Bank and other global organizations
- the growing influx of new technology firms collecting and tracking carbon footprint and other climate change data for a multitude of industries
- the higher frequency and severity of extreme flooding events
Strengthened loan documents from financial institutions
Financial institutions will similarly strengthen their loan documents to adequately protect their extension of capital to properties that are subject to material climate risks such as extreme flooding. These more restrictive loan covenants might take the obvious form of greater insurance coverage amounts and longer policy terms. Other loan requirements might include charging interest rate premiums or fees, obtaining guarantees from creditworthy sponsors and/or holding reserve funds to pay for flood-related damages and property value losses.
From the other side of the negotiating table, we can see borrowers and sponsors soon trying to limit their lenders’ flood insurance requirements to the extent they are “commercially available” or “available at commercially reasonable prices.” Similar to how future premiums for terrorism insurance coverage today in commercial mortgage loans are sometimes limited to a maximum cap amount based on the present cost of property coverage, one can see how a borrower might push for flood insurance to be handled in the same way, especially if the cost of this coverage has sky rocketed due to a major flooding event or the lack of a government backstop.
Unfortunately, as history has shown time and time again, nothing changes government policy faster than a national disaster.
Another commercial real estate finance document we predict will be impacted by climate change flooding is the disclosure required by law to be made by issuers to the investors who purchase securities backed by the mortgages securing these properties. Today these disclosure documents — sometimes called an offering memorandum or a prospectus — will describe the risks of SFHA properties and flood insurance in a very general way.
Inadequacies of standard insurance, even for types of losses that are insured against
The mortgage loans do not all require flood insurance on the related mortgaged properties unless they are in a flood zone and flood insurance is available. In certain instances, even where the related mortgaged property was in a flood zone and flood insurance was available, it was not required. The NFIP will expire on September 30, 2020. If the NFIP is not reauthorized, it could have an adverse effect on the value of properties in flood zones or their ability to repair or rebuild after flood damage.
There is no standard climate change risk factor in CMBS disclosure documents to date. In response to both heightened investor demand and/or new regulations, we expect more robust disclosure related to flood zones to be included in these disclosure documents in the near future. Enhanced disclosure might take the form of more data on the recent flooding history of the subject property’s surrounding area, including damages and insurance claim figures. Other examples might include:
- carbon footprint and energy efficiency data for the building and its municipality
- a summary of the recent local infrastructure improvements made to combat flooding and improve drainage, sewage and transportation systems
- enhanced reporting concerning the applicable flood insurance companies beyond the alphabetical rating designated by the rating agencies
The need for enhanced disclosure will likely result in lenders doing more due diligence on climate change risks and hiring outside consultants to prepare special assessments in support thereof. In addition to the appraisal, property condition report and environmental assessment, it might not be too long before a climate change report is also required for new commercial real estate loans, particularly for properties in flood zones or those where real data about the property’s susceptibility to flooding tells a different story than an outdated FEMA flood map.
Changes the flood insurance industry may take in the near future
FEMA flood maps are likely to be updated more frequently to account for actual climate change impact and receive technical assistance from climate experts like Four Twenty Seven.
Inaccurate FEMA flood maps do not provide the consumer with reliable information regarding flood exposure and contribute to NFIP coverage rates that do not accurately reflect the risk of loss — or in an egregious example, do not identify a property as being in a flood zone despite having a recent history of flooding. FEMA will become more actively involved in the process of updating flood maps in order to enforce uniform standards nationwide and inform the public of their actual risks, including the ability to obtain protection of insurance under NFIP.
Additionally, the near guarantee of the availability of flood insurance may contribute to a lack of regard for the increasing threat of flooding in coastal and low-lying areas — frequently referred to as the “moral hazard” problem. Another potential change we think is not impossible to consider would be for the federal government to withdraw the availability of NFIP coverage in certain flood-prone areas. The result would be that property owners must solely bear the cost of flood damage or pay the increased cost of private flood insurance (if available) in order to mitigate the risks. This would drive up operating expenses for property owners and impact the net operating income figures that banks analyze when underwriting loans.
At present, NFIP cannot refuse to insure a property because it has a history of flood-related losses. However, the risk currently held by NFIP could be rebalanced and NFIP could refuse coverage to properties that have been repeatedly damaged by floods, which according to FEMA account for approximately 30% of all claims paid out since the inception of NFIP. In particular, there is a concentration of 10,000 properties in five states that have experienced repeated flood losses: Florida, Louisiana, New Jersey, New York and Texas.
