The world of commercial real estate is facing a perfect storm of challenges. While the demand for rental properties remains strong, the expenses associated with owning and developing these properties are skyrocketing. In this blog post, we'll delve into the factors behind this phenomenon, its impact on developers and property owners, and how it may reshape the real estate landscape.
Apartment Expenses on the Rise: Apartment expenses are climbing at an alarming rate, far outpacing rent increases. Insurance costs, in particular, are skyrocketing, and providers are introducing new policy limitations to limit their exposure. This situation is most pronounced in states with high environmental risk factors, such as Florida, California, and Texas.
As of June 2023, the average U.S. quarterly apartment premium has reached $180 per unit, marking a staggering 33 percent year-over-year increase. This sharp rise means that insurance expenses now make up more than 8 percent of an owner's quarterly per-unit operating costs, almost double the figure from five years ago. When combined with escalating property taxes and payroll expenses, the total expenses associated with apartment ownership have surged by 9 percent in the past year. In stark contrast, the national average effective rent has only risen by 4 percent. This growing disparity and expectations of further cost increases are poised to influence development proposals, property valuations, and investor acquisition criteria significantly.
Developers Hit the Brakes: The sharp increase in insurance premiums, along with higher labor, materials, and financing costs, is making it increasingly challenging for developers to justify ground-up developments. This scenario is leading to a potential pullback in U.S. project starts, a trend already beginning to take shape. In the first half of this year, the total value of all commercial starts plummeted by 11 percent, and the number of permits issued for new multifamily projects hit its lowest point since late 2020. Despite this slowdown, an oversupply of 400,000 units in 2023 is expected to raise the nation's vacancy rate to a 12-year high of 5.7 percent.
Favoring Net-Leased Assets: Given the accelerated insurance costs and their impact on property valuations, some investors may find it increasingly difficult to underwrite acquisitions in the coming years. This dynamic could negatively affect localized deal flow, particularly in areas at high risk of weather-induced property damage. Moreover, the elevated insurance costs may eat into merchant builders' profits when selling newly-built or pre-stabilized properties, as current premiums are significantly higher than when these developments were initially financed. Given these market conditions, an ownership model where tenants bear all insurance and property maintenance costs may become an attractive investment option, potentially boosting the outlook for net-leased transaction activity and sale-leaseback velocity.
Impact on Cost of Living: The rising cost of insurance is not only affecting the commercial sector but also driving up the cost of single-family homeownership. In states where national providers are limiting or ceasing new policies, prospective homeowners are likely to be deterred, especially in regions renowned for their lower cost of living. Some households may opt to rent instead, potentially benefiting multifamily property owners. However, the increased cost of insuring apartments may also affect renters, as property owners may have to divert funds from upgrades, potentially lowering the quality of rental properties.
Insurance Exodus and Regional Impact: Eight out of the ten major U.S. metros with the highest second-quarter multifamily premiums are located in Florida or California. This trend is set to continue as the exit of major insurance providers in these high-risk states will have far-reaching consequences on policies and rates. For instance, in Florida, Farmers Insurance's departure is set to put pressure on the state-run Citizens Property Insurance Corporation, potentially leading to a significant premium increase of up to 12 percent. In California, the exodus of State Farm and Allstate may impact renewals and new policies, raising concerns for owners of older buildings needing seismic upgrades and properties in wildfire-prone zones.
Less Regulation in Texas: While Texas is not exempt from rising insurance costs, particularly in Houston and Fort Worth, where the average cost to insure a unit rose by more than 40 percent year-over-year, the state operates differently. Texas follows a "file and use" policy, allowing insurance companies to immediately raise premiums after filing a request with the state's Department of Insurance, without waiting for approval. Last year, nearly 90 percent of rate adjustments submitted were approved, indicating that insurers are unlikely to exit the state, and more increases may be on the horizon for owners and developers.
The commercial real estate landscape is undergoing significant changes, driven by rising expenses, especially in insurance costs. These challenges are leading to adjustments in development strategies, property valuations, and ownership models. As the real estate industry navigates this complex terrain, investors, developers, and property owners will need to adapt to these new dynamics to thrive in an ever-evolving market.