The Federal Reserve's plan to slowly raise interest rates in 2017 could have the unintended effect of driving up property and casualty claims and insurance costs for middle market commercial real estate investors and owners.
The Fed's decision on rates reflects a positive view that the U.S. economy is recovering and no longer needs to be supported by artificially low rates. For the real estate industry, however, there's another side to this issue: Critically needed capital expenditures such as upgrades to heating and air conditioning systems, roofing, flooring, as well as major electrical and plumbing work could be tabled as real estate companies seek to trim costs and save money in an environment that makes borrowing more expensive.
Over the next five to 10 years, the pressure for real estate firms to meet cash-flow projections will result in further capital expenditure reductions and increased insurance premiums, eventually impacting net incomes and long-term valuations as I wrote in a recent whitepaper titled, “Interest Rates, Capex, and the Inevitable Real Estate Conundrum.”
Many real estate firms are likely to find themselves in this conundrum given the considerable capital required to buy an asset, maintain that asset and hopefully grow and remain competitive. Several real estate executives cited in the whitepaper share this view.
For instance, Shelby Christensen, a senior vice president at Liberty Property Trust, said higher interest rates, combined with challenging financial conditions, “would certainly cause many real estate investors, especially those who lack deep capitalization, to think twice about certain Capex.” Less-capitalized or highly levered real estate investors are disproportionately at risk because they don't have deep cash reserves like larger real estate groups.
Jerry Sweeney, president and CEO of Brandywine Realty, also agrees that the effect on smaller, highly levered real estate developers and investors could be significant. “Capex, [specifically] maintenance and building improvements, is likely to take a hit to counter higher costs across the board,” Sweeny said.
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|Impact on insurance claims and costs
In 2016 a Mid-Atlantic based apartment group suffered a devastating loss when boiler exhaust pipes, likely due to rust and corrosion, leaked carbon monoxide and killed several residents. The real estate company involved in this ongoing case is facing millions of dollars in defense costs.
The importance of depreciation could take on a whole new meaning if your firm finds itself in this situation. Not only will your annual insurance costs increase as a result, but it could lead to even greater inflated or unrealistic valuations, which could have a ripple effect in the industry if you factor in market uncertainty.
Consider another potential area of vulnerability: In the event of a catastrophic storm, a real estate company that has deferred roof repairs typically conducted every 10 years could find itself facing a million-dollar repair bill rather than a $100,000 claim for roof damage.
Meanwhile, as claims mount against the real estate company, insurance brokers or consultants could lose leverage regarding their ability to negotiate favorable terms and pricing with insurance carriers.
Increased claims resulting from deferring capital expenditures also would shrink the market as many carriers will deny quoting certain risks. For most companies, it will most likely take three to five years for insurance costs to level off since that is usually the length of time the average loss is counted against a company.
Over time, a reduction in Capex will lead to faster degradation of asset quality due to increased competition and consumer demands changing, all of which would affect long-term cash flow and insurance costs.
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Solutions for real estate companies
Property owners should resist the temptation to reduce Capex reserves when rates increase. A slight increase in Capex will, in fact, give most real estate groups an edge over their competition. It also bodes well for their insurance program and correlated premiums.
Documenting your ability to increase your Capex allocation slightly or maintain current Capex levels is also important. Presently, the property insurance market remains competitive, but a company that can manage to at least maintain its current Capex levels, and improves or maintains a good loss ratio, would have a competitive advantage over its peers.
Also, instead of reducing Capex your company should seek tailored insurance programs, comprehensive coverages and cost-effective risk management programs – with the help of an experienced broker.
Whether you're a property manager, investor or insurer, the potential impact of rising interest rates on Capex, insurance costs and valuations are too significant to ignore.
The key to future success for middle market commercial real estate investors and owners is to have proactive, internal conversations regarding strategy and capital allocations, and make sure they have an experienced insurance broker by their side to help them better evaluate the potential impact of any difficult decision they may have to make.
Geoffrey Pope is vice president, USI Insurance Services. To receive a copy of the whitepaper, “Interest Rates, Capex, and the Inevitable Real Estate Conundrum,” or to learn about USI's solutions for real estate companies, contact [email protected].
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