How Climate Change Could Affect The Future Of Real Estate Investing
In 2009, the Federal Emergency Management Agency conducted a simulation known as Phoenix. The project was an attempt to predict and prepare for the damage that a fictional Category 5 hurricane named Phoenix would do if it made landfall in Tampa Bay, Florida. To say the predictions were dire would be an understatement.
A storm like Phoenix would result in 160 deaths, leave 30,000 people missing and another 300,000 homeless. The economic cost was estimated at nearly $200 billion.
That’s why many people feared the worst when Hurricane Ian began tracking toward Tampa Bay last week. Although it made landfall as a Category 4 in Naples, the damage wrought by its 6-12 foot storm surge and 150-plus mph winds was still devastating.
Over 2 million Floridians remain without power, and it’s still too early to get reliable property damage estimates. But one thing remains certain. Storms are getting stronger and more frequent. It’s only a matter of time before the real Phoenix takes aim at Tampa or another American city. Climate change is no longer a theoretical hazard. It’s real and it’s happening right now. So, how will this change the future of real estate investing?
The Risks Will Touch Every Real Estate Market
During the COVID crisis and its aftermath, there was a large migration of Americans moving out of major cities in both the Northeast and the West. Many of them headed to the warmer climates of the Sun Belt. One of the preferred destinations was central Florida, where both Tampa Bay and Orlando experienced a mini-boom in housing prices.
Developers took notice and many real estate investment trusts (REITs) began investing heavily in new housing opportunities in these markets. Even as those markets begin to cool because of rising interest rates, the risk of other natural disasters hitting the Sun Belt will only continue to increase. When Hurricane Andrew slammed into Miami in 1992, it did nearly $26 billion in damage. As scary as that number sounds, a similar storm would probably do several times that much damage today.
Other major Sun Belt real estate markets such as Houston and New Orleans also exist in perpetual danger of a hurricane worse than Ike (2008) or Katrina (2005). Both of those storms did billions of dollars in damage, and any investor who had projects under development when they hit suffered mightily. Basically the warming waters of the Gulf of Mexico and south Atlantic Ocean are acting as the worst kinds of performance enhancer for hurricanes. That also means the Sun Belt is no longer the only potential danger zone.
In 2012, superstorm Sandy wreaked havoc on the Eastern Seaboard and did nearly $80 billion in damage to 24 states. That’s literally half the country. The scary part is, that’s still not the worst-case scenario. A repeat of the New England Hurricane of 1938, also known as the Long Island Express, would cause unthinkable destruction. When that storm hit Long Island, there were a few hundred thousand people living there. Today, there are almost 1.5 million.
The dangers out West are also multiplying. A recent weather simulation known as the ARkStorm predicted what would happen if a series of atmospheric rivers struck California. Atmospheric rivers are superstorms, usually powered by warm water, that literally dump biblical amounts of rain for several weeks or perhaps even months at a time.
The study found that California’s infrastructure is not nearly equipped to withstand such an event, and if the ARkStorm were to hit, it would leave 1.5 million people homeless. The Port of Los Angeles and Long Beach would be underwater for months. That would make the COVID-related supply chain challenges of 2020 and 2021 look like a walk in the park. The ARkStorm would literally devastate California’s economy and, by extension, the nation’s.
The ARKstorm is only one of the potentially devastating risks California is facing. The danger of wildfires grows every year. There used to be a “fire season” that lasted from late summer to early fall. Fire season is now 12 months a year in California. This is thanks in part to the same drought that is drying up the state’s water supply at an alarming rate. In fact, the water supply for the entire west coast is under threat.
As the world continues to warm, these nightmare scenarios become much more realistic possibilities. There isn’t a real estate market in the country that would remain unaffected by disasters of this magnitude. It’s not impossible to imagine two or three of these disasters striking in the same year. Even one might be too many. Wall Street and New York’s financial district sit at sea level. Another Long Island Express would shut it down for months.
The Effect On Real Estate Development And Investing
When it comes to predicting the effects of climate change on real estate, the following four areas of risk stand out immediately:
- Location
- Construction costs
- Infrastructure
- Insurance
Location: The United States has followed a pattern of population growth similar to that of most societies in history. America’s major population and commercial centers are largely clustered along its coasts. New York City, Chicago, Boston, Los Angeles, Miami, Houston and San Francisco all border large bodies of water. The combined population of these cities and their metropolitan areas is somewhere around 100 million people.
Relocating all of them to the nation’s interior is not feasible. First, the Midwest and Bible Belt are not immune to the effects of climate change. Hurricanes and other natural disasters can do as much damage with inland flooding as they do to the coastal areas they slam into. Second, moving 100 million Americans into the interior would result in the loss of millions of acres of the farmland that feeds America.
Third, as America’s political divisions become even more pronounced, the country is fracturing largely along regional lines. It’s difficult to imagine a harmonious coexistence between millions of climate refugees from America’s mostly liberal coastal cities and the residents of the country’s more conservative base in the heartland. That’s the very definition of a shotgun wedding that nobody wants.
Construction costs: If it’s not feasible to relocate one-third of America’s population from its coasts to the interior, the only remaining option is to radically increase the quality of real estate construction in the country’s coastal population centers. That means municipal building codes, many of which were designed to suit a 1 in 10- or 20-year storm, must be upgraded to reflect the new reality.
The 1 in 100-year storm that was once considered too expensive and impractical to build for might be the new 1 in 10-year storm. If that’s the case, real estate developers, and the investors who fund them, will face astronomical cost increases for everything from building materials to the actual construction itself.
Think of a racecar that is built to withstand crashes at several hundred miles per hour while still giving the driver a high chance of survival. The reason everyday passenger cars aren’t built to that standard is all that crash resistance costs money. The average car for NASCAR racing costs hundreds of thousands of dollars to build. That’s why it’s not practical to build everyday passenger cars to that standard.
As it stands, modern construction costs mean the only housing sector that developers really make money building in is the luxury sector. If real estate developers have to start building apartments and houses to hurricane or natural disaster standards, the end cost for buyers and renters will be astronomical. Not only that, the opportunity costs for developers may be so prohibitive that it keeps them from building new developments at all.
So, the prospect of adjusting costs upward to comply with revised building codes is a terrifying thing to consider from a developer’s perspective. The same thing holds true for commercial properties like offices, hospitals and shopping centers. If developers are paying more, that means the investors they depend on for capital are going to be paying more.
Those added costs eat heavily into profits. That raises the question of whether there will even be enough investors willing to contribute to projects with radically higher costs to achieve the same profit margins they’ve gotten in the past. This is especially true considering that the question of whether there are enough homebuyers and tenants to pay these increased costs also remains unanswered.
Infrastructure: It’s not just private construction projects that will have to be hardened and made more resistant to the effects of climate change. All private construction, regardless of what sector it’s built in, depends on public infrastructure. A short list of the public infrastructure that will need to be upgraded includes:
- Roads, bridges, streets and freeways
- Electrical grids
- Municipal water and sewage
- Internet and telephone towers
- Emergency services like fire departments and police
There is only one way to fund those upgrades: raising taxes. Take a minute to consider that popular Sun Belt states like Texas and Florida have no state income tax or that Prop 13 in California basically makes raising property tax rates impossible. It doesn’t take long to see how trying to raise funds for the infrastructure upgrades necessitated by climate change will be a political nightmare for whoever is brave enough to try it.
Because all real estate investing and development depends on high-quality infrastructure, there is simply no way that some of the costs of upgrading it won’t fall on developers and investors. Maybe the tax breaks they used to get to break ground on new projects will be reduced. Perhaps they will disappear entirely. Any way you slice it, this is another cost that real estate investors will be bearing in one form or another.
Insurance: It’s easy to beat up on the insurance industry, and there are times when the industry (or certain bad actors in the industry) deserve the public flogging they take. However, the fact remains that insurance is a very necessary evil when it comes to real estate investing and real estate development. Without insurance to cover the risk of catastrophe, there probably wouldn’t be any real estate development at all.
Every insurance company has actuarial tables that calculate the risk of loss on the policies they issue. As that risk increases or becomes more prevalent, the only way for the insurance company to make money on the policies is to increase premiums. That’s why it costs more to insure a 16-year-old kid driving a new Mustang GT than it does to insure a 50-year-old man driving the same car.
This is where the success of real estate investors and developers at increasing property values will come back to haunt them. The potential risk a massive natural disaster such as the ARkStorm or another Long Island Express poses to insurance companies is obvious. As much as everyone likes to beat up on insurance companies as “bad slot machines” that collect money but never pay out, multiple natural disasters in a short timespan could bankrupt them.
Imagine a Long Island Express, an ARkStorm and a Hurricane Andrew all hitting in the same year. There is a very real risk of that happening, and if it did, it’s not inconceivable that several major insurers could all go bankrupt at the same time. That risk is very real when you consider the dramatic appreciation of property values in Florida, New York and California over the last several decades.
Needless to say, one or more of the nation’s largest insurance companies going under simultaneously after a natural disaster would leave millions of Americans holding the bag at the worst possible time. The only way they can guard against that is to raise premiums. That’s yet another cost that will be passed on to real estate developers and investors. It’s also another line item that’s going to eat into profits.
Final Thoughts
As you can see, climate change will pose serious challenges to real estate investors. As the effects of climate change continue to manifest themselves, those challenges will become more pronounced and more difficult to overcome. The end reality is that investors will have to innovate and find new methods of building more climate catastrophe-resistant structures.
One potential place to look is shipping containers, which are already being repurposed as residences. These hardened steel boxes are built to protect their contents against the most violent storms imaginable on the open seas, and they are stackable. However, that’s only part of the equation. Ultimately, real estate investors are going to have to get a lot smarter and a lot more discerning about where they put their money.
Because the good old days of backing REITs with assets concentrated in prime real estate markets and just waiting for the money to flow in are going to be over soon. Climate change is going to make sure of that. As an investor, you may want to shift your focus to real estate-related innovations that will help mitigate its effects. The race is on to build a better mousetrap.
