Flood Insurance, Commercial Real Estate and Climate Change

Dechert LLP

Dechert LLP

Climate change is forcing the commercial real estate industry to re-think the effectiveness of flood insurance that developers, lenders and investors have relied on for decades.

Rising sea levels and more extreme weather events could push that reliance to a breaking point. In 2018, approximately US$91 billion in damages resulted from 14 weather and climate disasters in the United States alone, each with losses exceeding US$1 billion, mostly to residential and commercial real estate.

Flood insurance is one of many areas of concern that climate change is bringing to the commercial real estate finance industry.

Limitations of the National Flood Insurance Program and FEMA flood maps

street sign flooded

Congress created the National Flood Insurance Program (NFIP) as a division of the Federal Emergency Management Agency (FEMA) in 1968. It is a federally underwritten flood insurance program intended to offset the expense of disaster relief by requiring floodplain occupants to pay premiums into an insurance pool. The program was created to fill the vacuum left by private insurers who no longer found it profitable to insure coastal and low-lying areas at a high risk of flooding.

Today, NFIP coverage is provided by roughly 60 different insurance companies and written through hundreds of licensed insurance agents across the country. As of late 2019, NFIP had approximately 5.1 million outstanding flood insurance policies in at least 22,387 communities with approximately US$1.3 trillion of flood insurance coverage.

National Flood Insurance Program is financially unstable

It is heavily subsidized by FEMA and funded year-to-year by Congress. At present, NFIP carries US$20.5 billion in debt owed to the U.S. Treasury, even after Congress cancelled US$16 billion of NFIP’s debt in 2017 to pay claims for Hurricanes Harvey, Irma and Maria. Maintaining this level of debt is unsustainable.

Many experts say NFIP is virtually insolvent and needs to be re-designed to continue to be the favored backstop to flood damage in this country. Looking at the math, this is easy to see. In 2018, NFIP only collected approximately US$3.6 billion in annual premium revenue but paid out approximately US$9.7 billion in flood insurance claims and incurred approximately US$2.6 billion of administrative expenses. One catastrophic storm can easily wipe out not only thousands of miles of low-lying real estate, but also the NFIP’s bank account. For Superstorm Sandy alone, the NFIP pay-out was in excess of US$8 billion.

On December 20, 2019, U.S. President Donald J. Trump reauthorized NFIP’s statutory authority to operate through September 30, 2020. Currently, the statutory borrowing limit for NFIP is US$30.4 billion. If NFIP is not reauthorized on or prior to this latest deadline, the borrowing authority for NFIP will be reduced to US$1 billion and its license to issue or renew flood insurance policies will stop. The potential for disruption is most concerning for property owners in special flood hazard areas (“SFHAs”) seeking mortgages from federally-backed entities and federally regulated banks because flood insurance is legally required for these loans.

Other shortcomings of flood insurance

Aside from the overall financial weakness of NFIP, flood insurance has other structural limitations. Insurance coverage availability and flood zone designations are determined by today’s risks — not future, potential risks.

Insurance policies typically only have one- or two-year terms. Premiums are based on historical data, and do not take into account climate change over time. Flood insurance premium rates look to FEMA flood maps to inform communities on historically flood-prone land, and to influence development and construction ordinances. FEMA is required by law to assess if there is a need to revise and update its flood maps every five years. However, there is no requirement to actually update or revise FEMA flood maps with such frequency.

Outdated FEMA flood risk metrics

Further, FEMA flood risk metrics rely on backward-looking data, including historical flooding patterns. They do not take into account future sea level change or increased flooding estimates. Depending on global carbon emissions over the next several decades, climate change researchers claim that sea levels will rise by about one to two feet by 2050 and by as many as three to five feet by the end of the century. This is troubling when it has been reported that two-thirds of all FEMA flood maps have an effective date older than five years.

This has led to costly and catastrophic errors. For example, in 2018, at least 140 Florida homes were demolished following the destruction of Hurricane Michael. However, the relevant FEMA flood map reflected that the properties were in flood zone X (0.2% chance of flood in any year) and flood insurance was not required. The last time this particular flood map had been updated by FEMA was 2009.

To differentiate between high- and low-risk areas for flooding, FEMA uses different letters of the alphabet for flood maps. SFHAs are designated areas of land in either flood zone A or flood zone V which means they are exposed to a one percent (1%) or greater risk of annual flooding (i.e. the “hundred-year flood”).

Of particular significance is that the “hundred-year flood” is often misunderstood—it is not a factor of time, but rather is an expression of risk. The land in question has a 1% chance of flooding each year, making it possible to have a hundred-year flood in consecutive years. As climate change causes more flooding, the “hundred-year flood” risk is occurring more frequently, and impacting more land. Accordingly, the 1% chance of risk is understating the reality, as flooding becomes less a chance and more a certainty.

Loss of value not covered

Another inherent limitation of flood insurance is that it covers damages, not loss of value. Flood insurance is effective in providing financial protection against physical damage to commercial real estate due to extreme flooding. Yet, that same insurance policy will not provide any relief for devaluation of properties seen as increasingly vulnerable to flooding and other climate change risks. When coupled with the fact that insurance policies need to be renewed every one to two years, this can leave real estate owners and investors not only vulnerable to higher premiums and unavailability of coverage, but also the risk of market value loss year over year.

The worst-case scenario here is particularly bleak. Billions of dollars of real estate will be underwater not only in terms of their market value being less than the outstanding mortgage debt, but also because these properties will be at greater risk of someday being literally underwater. Refinancing these mortgages and insuring these properties will undoubtedly become more challenging each passing year.

Public and private efforts to combat extreme flooding

Miami shore

The combination of the increased frequency and severity of extreme flooding events and the structural and financial limitations of flood insurance have caused many public and private sector participants to take matters into their own hands. Many examples can be seen across the country, primarily in coastal states, cities and towns.

Actions on the municipal and state levels

In October 2019, New Jersey Governor Phil Murphy marked the seventh anniversary of Hurricane Sandy by signing Executive Order No. 89 in order to establish a statewide Climate Change Resilience Strategy. This new public initiative will develop and deliver a science-based report on climate change concerning the current and anticipated impact of climate change in New Jersey, including sea level rise and the increased frequency and severity of flooding through 2050. This report will be delivered to the governor by April 2020 and updated every two years.

Miami, Florida, in 2013 embarked on a US$600 million storm water management initiative to elevate roads and install state-of-the-art water pumps. More recently, the local government approved the “Miami Forever Bond” issuance aimed at financing various building improvements and infrastructure fortifications designed to control flooding, improve draining and protect communities.

Many major cities from coast to coast have launched efforts to tackle flooding concerns from a variety of vantage points — from plans to build sea walls around lower Manhattan and the San Francisco International Airport to San Francisco’s 2019 ordinance requiring sellers and landlords of all real property (residential and commercial) to provide prospective buyers and tenants with special flood risk disclosure — all with the goal of increasing preparedness and awareness.

Smaller cities and states are also taking steps to protect their property from the dangers of extreme flooding. The town of Oak Bluffs on Martha’s Vineyard, Massachusetts adopted amendments to its Floodplain Overlay District Bylaw, which prohibits new residential development and expansion of existing development in flood zones V, VE and AO. The amendments also require that construction in flood zone A meet design criteria and performance standards and receive construction approvals from the town through a special permitting process.

Additionally, the State of Rhode Island recently developed the Coastal Environmental Risk Index, a detailed and accurate flood map, which is available online and based upon a methodology that assesses the risk that buildings face from storm surges, factoring in sea level rise and shoreline erosion.

Actions from the private sector

The private sector also is working to educate developers, lenders and investors looking to implement climate change risk into their commercial real estate investments. In June 2019, Fitch Ratings announced its intention to be the first major rating agency to include natural disaster and catastrophic risk into the ratings analysis of residential mortgage-backed securities.

In July 2019, Moody’s Corporation, which rated approximately 43.1% (more than US$42 billion) of all U.S. CMBS transactions in 2019, acquired a majority stake in the Berkeley, California-based research firm Four Twenty Seven. Four Twenty Seven provides market intelligence on the impacts of climate change for financial markets. Four Twenty Seven is able to provide clients with climate change data on REITs overall and the properties held in each REIT. Its research assigns risk scores based on exposure to heat stress, water stress, floods, sea level rise, hurricanes or typhoons.

The data analytics generated by companies like Four Twenty Seven are able to move away from strict reliance on FEMA flood maps and evaluate climate change concerns at a more forward-looking and practical level. This acquisition is a clear signal that Moody’s is looking ahead and is likely to include climate change risk into its overall risk analytics and ratings methodology for commercial real estate investments.

How banks and insurance companies are preparing for increased flooding

Hurricane near Florida

The commercial real estate finance industry has no uniform strategy to underwrite the increased frequency and severity of flooding due to climate change.

Part of this uncertainty is driven by the reality that the flood insurance industry (both public and private) is at a crossroads of how to underwrite climate change risks effectively. Both will soon be forced to adjust to face the environmental and economic realities of a country more prone to frequent, catastrophic and repeated flooding. We believe certain key adjustments will occur to both industries in the near future.

Stricter underwriting standards among banks and lenders

Either through greater investor demand and/or new financial regulations, banks and other lending institutions are likely to employ stricter underwriting standards when making loans secured by commercial real estate located in SFHAs and other high-risk flooding areas. These more restrictive requirements will be seen first in the legal documentation that evidences both the origination and sale of commercial real estate loans. A typical loan application today will have very limited detail about flood insurance, as it is usually included in a long list of insurance coverages required by the bank. Such a clause might read as follows:

— “Receipt and approval by Lender of property, liability, rent loss, builders risk, workers compensation, terrorism, and flood insurance as well as any other insurance deemed necessary by the Lender.”

A mortgage or loan agreement will also use general language requiring a borrower to maintain the NFIP minimum flood coverage or other coverage required by the lender if the subject property is located in a SFHA. An example of this covenant often reads:

— “if the Property is now or hereinafter located in a FEMA designated “special flood hazard area”, flood insurance in an amount equal to not less than the lesser of (A) the maximum amount of such insurance available under NFIP, (B) the Loan amount, or (C) the insurable value of the Property, together with such “excess flood” insurance Lender reasonably requires.”

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.

What to expect going forward

flooded city

Superstorm Sandy provides an important warning. Climate scientists say that in the late 1800s this type of powerful storm was a once-in-500 year event for the New York City tri-state area. As of 2017, the probability was revised to be a once-in-25 year event. And by 2030, it is now predicted to be a once-in-five year event.

Looking more broadly at the U.S. as a whole, in roughly the last 10 years, there have been 17 once-in-a-1,000 year downpour events across the country. By definition, once-in-a-1,000 year flood events are supposed to happen once-in-a-1,000 years. Therefore, the occurrence of 17 such events in less than a decade makes a very obvious point.

Miami and the NYC/Newark metro areas are the number 1 and 3 geographic areas, respectively, most at risk of asset value loss from sea level rise over the next 50 years by asset value. More than US$130 billion worth of real estate in Manhattan is located in a flood zone.

Against the backdrop of these staggering figures, we must closely follow how the commercial real estate finance and flood insurance industries will adapt in the coming years, especially with the U.S. economic expansion now entering an unprecedented second decade.

Among the questions are whether the National Flood Insurance Program will be reformed, whether private flood insurers raise their rates to levels only wealthy real estate sponsors can afford, and whether banks and real estate bond buyers will call for more detailed disclosure to more accurately balance the risk of loss. The recent annual letter written by BlackRock CEO Larry Fink calling out climate risk as a serious investment risk clearly shows which way the weather vane is pointing.

We know the commercial real estate finance industry to be incredibly resilient and anticipate it will be ready to meet the challenge of more extreme flooding. From the Terrorism Risk Insurance Protection and Reauthorization Act, to the risk retention rules under the Dodd-Frank Act, the recent HVCRE regulations and the ongoing phase-out of LIBOR, the commercial real estate industry has proven time and time again that it can evolve to all types of changes to the marketplace.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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