The commercial real estate sector, already reeling from pandemic-related vacancies and rising interest rates, now faces another significant challenge: skyrocketing insurance costs. These increases are driven by the growing frequency of climate-related natural disasters, creating a long-term burden for property owners across the country.
This problem is not confined to individual homeowners but has become a critical issue for owners of commercial properties like shopping centers, office buildings, and apartment complexes. As the frequency of extreme weather events escalates, insurers are dramatically raising premiums or exiting certain markets altogether. While coastal cities remain the most vulnerable, no region is truly immune to the financial toll of unpredictable climate events.
Recent hurricanes, such as Hurricane Helene and Hurricane Milton, wreaked havoc across parts of the southeastern United States, contributing to the potential $75 billion insurance bill. As a result, commercial property owners are finding themselves stuck between insurers demanding higher premiums and lenders refusing to allow any leniency on coverage requirements.
Insurance Costs Jeopardize Commercial Real Estate Deals
Although it is difficult to quantify how many properties have faced foreclosure solely due to rising insurance costs, experts agree that the issue has disrupted numerous deals. Landlords and developers already grappling with increased borrowing costs and labor expenses are finding that rising insurance premiums can tip the scales, making some investments untenable.
Mario Kilifarski, head of asset management at Fundamental Advisors, noted, “This current interest-rate environment has exposed who really understands what they’re doing.” Kilifarski, whose firm manages $3.5 billion in assets, emphasized that higher insurance premiums are now one of the many factors impacting the commercial real estate sector.
According to Marsh McLennan, a leading insurance brokerage, commercial property premiums rose by an average of 11% across the country last year. However, in high-risk areas such as the Gulf Coast and California, the increases were significantly steeper, with some regions seeing rates jump by as much as 50%. In 2024, certain locations are witnessing premium hikes that could effectively double their costs.
The increased burden is hitting residential rental properties particularly hard. Insurance now accounts for about 8% of operating expenses for apartment buildings, double what it was five years ago, according to Paul Fiorilla, director of research at Yardi Matrix. Although this still represents a small portion of total operating costs, it exacerbates the financial pressures caused by stagnating rents and elevated borrowing rates.
Lenders Reluctant to Offer Relief
Lenders are growing increasingly anxious about the implications of rising insurance costs. Kevin Kaseff, co-founder of Titan Real Estate Investment Group, a California-based firm with a portfolio of senior living facilities and cold-storage warehouses, noted that lenders are becoming more inquisitive about insurance coverage, particularly for properties in states like California, where several major insurers have stopped offering new policies.
“They’re nervous,” Kaseff said, adding that while lenders eagerly request updates on insurance plans, they show little willingness to relax their strict requirements.
Like homeowners, commercial property owners with mortgages are required to maintain insurance coverage. However, the stipulations for commercial borrowers are often stricter, requiring explicit lender approval for even minor changes to coverage. For borrowers whose loans have been securitized and sold to investors, gaining such approval can be an impossible task.
Tough Negotiations
Lenders’ reluctance to soften insurance requirements stems from concerns over market stability. In the event of a major disaster, uninsured properties may not be rebuilt, which could destabilize the real estate market and negatively impact the value of their collateral. Adam DeSanctis, a spokesperson for the Mortgage Bankers Association, explained that regulators are also closely monitoring the situation to avoid further risks to the financial system.
Developers like Kaseff argue that solutions are within reach. He suggests that banks could allow borrowers to purchase insurance with higher deductibles, thereby reducing costs, or permit coverage that insures only the value of the bank loan rather than the full cost of replacing a building. However, such concessions have so far been rare.
Danielle Lombardo, chair of the real estate, hospitality, and leisure division at Willis Towers Watson, an insurance brokerage, said that rising insurance costs are causing deals to stall and, in some cases, leading to foreclosure. “Insurance pricing has forced some deals to halt and has led others into foreclosure,” she said.
The Struggle for Solutions
In response to surging insurance costs, some property owners are adjusting their strategies. Kilifarski explained that instead of making cosmetic upgrades to apartments at a Corpus Christi property, his firm is focusing on cutting operational expenses by improving energy efficiency.
“We were planning to install stone countertops and upgraded appliances, but now we’re rethinking how we spend those dollars,” he said.
Despite these challenges, experts do not foresee a full-blown crisis in commercial real estate just yet. Nathan Stovall, director of financial institutions research at S&P Global Market Intelligence, said that loan delinquencies have risen modestly, reaching 1.5% of outstanding commercial real estate loans since late 2022. While delinquencies at large banks have risen to around 5%, they remain far below the 10% delinquency rates seen during the 2008 financial crisis.
Large banks are particularly exposed to these challenges, as they are often the lenders for the types of properties most affected by post-pandemic occupancy changes, such as office buildings in urban centers where remote work remains prevalent.
Relief on the Horizon?
In a small ray of hope, the Federal Reserve cut its benchmark interest rate by half a percentage point in September 2024, the first such move since rates skyrocketed in 2022 and 2023. More rate cuts are expected this year, offering some relief to commercial real estate owners. However, the industry still faces significant headwinds, as current rates remain higher than when many property owners first took out their loans.
With insurers becoming increasingly cautious and banks maintaining tight lending practices, property owners are left navigating a difficult path. DeSanctis of the Mortgage Bankers Association noted that insurance, once considered a routine task for mid-level managers, has now become a central focus for top executives. Conferences on risk management, once attracting small crowds, have doubled in size as lenders seek new strategies for managing these rising risks.
As hurricanes and other climate-related disasters continue to strike unexpectedly, mortgage bankers must adapt to a world where no region is immune to the growing threat of natural disasters.
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