In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Senior Commercial Economist Xander Snyder discuss the impact rising insurance premiums are having within the commercial real estate market and how CRE property owners are adapting.
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“It seems like mom-and-pop operators in disaster prone areas will bear the greatest brunt of these rising insurance premiums because they have the least ability to adjust. Expense management is going to be key area of focus for property managers in the years to come.” – Xander Snyder, senior commercial economist at First American
Xander Snyder - Hello and welcome to episode 113 of The Reconomy Podcast, where we discuss economic issues that impact real estate, housing, and affordability. I'm Xander Snyder, senior commercial economist at First American, and here with me is Mark Fleming, chief economist at First American. Hey Mark, something that's been on a lot of people's minds here in Los Angeles over the last two months has been the rising cost of property insurance. And this is especially true for homeowners who were directly impacted by the wildfires in January and are now grappling with the sometimes arduous process of filing and managing insurance claims.
Mark Fleming - Hey Xander, that can certainly be a challenging task. And, while we know that the price and availability of property insurance is becoming an increasing concern for homeowners across the country, obviously rising insurance premiums also impact the commercial property market.
Xander Snyder - Right, I mean to a certain degree, a building is a building, right? It's attached to the ground and it doesn't move. Which means that the types of events that can cause property damage can impact both commercial properties and residential properties alike. The difference between residential and commercial is the context that insurance-related considerations need to be made in.
Mark Fleming - A building is a building indeed, Xander. Before we get into all the heavy jargon, we're just going to keep it really simple. So we're going to talk about the commercial buildings. But first, of course, we know homeowners are required by lenders to carry property insurance that will at least cover the value of the mortgage. If you don't have a mortgage though, then there usually isn't some other entity mandating that you have property insurance for your home. But, of course, that does mean you're assuming all of the risk. If something happens to it, essentially you're self-insuring. This is happening more regularly in disaster-prone areas where insurance is either too expensive or even not available for owners to purchase. In fact, a study published last year by the Insurance Information Institute indicated that around 12% of U.S. homeowners are forgoing property insurance. Okay, well that doesn't seem like a big number, but that is an increase from just 5 % in 2015. More than double.
Xander Snyder - More than double. So, by contrast, commercial property owners almost always have property insurance. I've never personally come across a situation where this isn't the case. There's just usually too much money involved in owning and operating a larger commercial property to self-insure. And oftentimes, there are also other investors involved who aren't willing to take that sort of downside risk themselves. I'll add that most commercial properties are also purchased with some sort of a mortgage and so, similar to the residential side, commercial lenders require insurance. But, even if a commercial property were to be purchased with cash, all cash, a commercial property is still a type of investment. And without property insurance, the investor would be running the risk of a potential full loss of their investment, depending on the location, of course. So this makes insurance premiums one of the key operating expenses, or OPEX as we say in the industry, that every commercial property owner or operator needs to manage.
Mark Fleming - Yes, and the fact that commercial properties are typically run as a business rather than someone's long-term residence creates a perspective shift about how to think about insurance. A homeowner, for example, carries insurance to cover what is usually the largest investment they've made in their life, which comprises a substantial portion, if not the single largest portion of their wealth. The downside risk to losing your home is one thing, but on the commercial side, a single property is maybe just one of many properties in a portfolio. And as a result, expenses, or OPEX in the jargon that Xander so quickly introduced in this episode, are usually measured relative to the rental income that a building generates.
Xander Snyder - Right, and when you compare expenses to rental income, you can refer to it as OPEX’s margin.
Mark Fleming - More CRE jargon. Ooh, get it? Jargon on jargon. A jargon double right there. But, of course, there's usually some reason that the jargon exists. And, in the case of commercial properties, it's because it's more helpful to think about insurance costs relative to rental income rather than just the absolute premium cost, which is how a homeowner may think about it. That's because the rental income is also something that changes over time.
So, if rental income doubles, but your insurance premium only goes up by 20%, then you're spending less of your rental income on insurance, even though the insurance premium itself has increased. And I would guess, Xander, that would be an increase in your margin.
Xander Snyder - There'd be an increase in your profit margin, yeah, in that particular case, because rental income increases more than operating expenses.
Mark Fleming - But that's not the usual case as we'll see.
Xander Snyder - Yeah, right, right, right. So while we know that insurance premiums have increased over the last several years, so has rental income, which is why we're drawing this distinction, at least for most asset classes. So, compared to 2019, pre-pandemic, rental incomes have grown by approximately 20% on average. Insurance premiums, though, have increased by 34% and 50% for multifamily and non-residential properties, respectively, over that same timeframe. So, in other words, property insurance premiums have grown significantly more than rents, which puts pressure on operators' profit margins.
Mark Fleming - Gee, Xander, today you're all about margins, margins, margins, kind of sounds like Marcia, Marcia, Marcia, if you get it.
Xander Snyder - Just to be sure, the Brady Bunch doesn't count as our 1980s reference for the day, right Mark?
Mark Fleming - Not even close, millennial. The Brady Brunch was done by the mid-70s. You're killing me here, Xander. Come on, you gotta know your TV trivia. But maybe you can talk about how insurance expense margins have changed over the last several years from the numbers you just mentioned. We know they've increased, but by how much?
Xander Snyder - Right, so let's put a number to it. Well, before the pandemic, insurance expenses for your median building, so that is a building with a median insurance expense margin, that usually hovered in the range of about 1% to 2% of gross rental income. Not a figure that kept many building owners up at night. Now, since then though, that range has increased to about between 1.5% and 3.3%, depending on the type of property. If we look at multifamily property insurance, which has the highest insurance expense margin of all property types, we'd see that the figure grew from about 2% pre-pandemic to 3.3% in 2023. And the way to interpret that is rental incomes would need to increase by an additional 1.3% beyond the increases that have already occurred just to offset that higher insurance premium.
Mark Fleming - Okay, at first blush, 1.3%, that doesn't seem like a very severe increase. Instead of insurance heating up 2% of rental income for an apartment property, it's 3.3%. That's not so bad.
Xander Snyder - Well, as they say, real estate is all about location, location, location. And the numbers that I just shared were for buildings with median insurance premiums. So that is buildings in the middle of the pack that are not particularly exposed to severe weather events. But buildings that are in more disaster-prone areas have had much larger increases in insurance expense margins. So, for buildings in the top 5% by insurance expense burden, insurance margins have increased from between roughly 3% and 6% pre-pandemic to between 5% and 11% now, depending on the property type.
Mark Fleming - Now that is more substantial. In fact, I was expecting in the top 5 % to be even more than that. So, you know, maybe that's some silver lining here. But, if we were to pick one property type, let's say multifamily again, the interpretation would be similar.
Xander Snyder - Right, exactly. So, for multifamily buildings in that top 5% by insurance expense burden, pre-pandemic insurance margins were about 6.3% before the pandemic, and that's now grown to 10.8%. So that would mean that multifamily rental incomes would need to increase by an additional 4.5% the difference beyond what they've already increased over the last five years in order to make up for that lost income due to higher insurance premiums.
Mark Fleming - Okay, so seems like the main takeaway here from this discussion so far is that commercial property insurance costs are increasing everywhere. But, as always with real estate, location matters because the increase is substantially more in areas exposed to extreme weather events.
Xander Snyder - Exactly, I'd agree with that.
Mark Fleming - Okay, so then the question becomes, what's behind these increases? We've discussed the greater frequency of severe weather, obviously, which leads to larger losses for insurance companies who raise their premiums to offset that risk. But are there other drivers?
Xander Snyder - There are two other major drivers of property insurance premiums that are influencing current insurance trends. And the first is relatively simple. Price levels have increased over the last several years. And this is especially true for prices of construction materials. So higher construction material costs translate to higher replacement costs that insurance companies have to cover in the event that a property needs to be rebuilt or repaired. So, as a point of comparison, the consumer has experienced approximately a 23% increase in prices measured by the CPI, and this is cumulatively compared to pre-pandemic. But, by contrast, construction material prices have increased by almost 40%.
Mark Fleming - And for listeners that don't know, Xander, a little plug for you here. Xander regularly tracks construction material costs from the Producers Price Index when it's published. So be sure to check out Xander's social media feeds if you're interested in staying up to date with that 40% data point. It's not a headline data point, so we have to do some digging. Xander has to do some work to get those things out there. It's often harder to track down, but worth it.
Xander Snyder - Yeah, I definitely think that that's one data point worth keeping an eye on right now. But, besides higher replacement costs, to answer your question, I think the other main driver right now behind insurance premiums is the availability of reinsurance.
Mark Fleming - Hold up, reinsurance you say? Reinsurance? We need to first walk through how reinsurance works, I suspect. Imagine a regional insurance provider has issued coverage for say $20 million in damages, but doesn't really like the idea of being on the hook for all $20 million of it and would maybe prefer to be exposed to maybe half, at $10 million worth of loss. That regional insurer can essentially go to a reinsurance company and they will reinsure that additional 10 million to reduce their liability for essentially a premium fee. Unlike the frequency and severity of weather-related damages, which we talked about, and replacement costs, which are much higher than they were, reinsurance availability ebbs and flows depending upon the supply of capital in the reinsurance market. And, of course, that has to do with the risk tolerance of those providers of capital at any point in time. When reinsurance availability decreases, regional insurers are basically forced to be on the hook for more damages and, therefore, they raise their premiums to offset that risk. But, as those premiums increase, it makes the market more attractive to the reinsurers that attracts more capital back in and they're able to offset it more with reinsurers and keep a cap on rising premiums.
Xander Snyder - Right, so more reinsurance availability typically relieves upward pressure on insurance premiums and conversely, less reinsurance availability drives insurance premiums up. So, in terms of where it stands today, reinsurance availability was in pretty short supply in 2022 and 2023, but that trend seems to be reversing, and in 2024 reinsurance availability began to increase. So that's definitely a silver lining in what's otherwise a somewhat challenging insurance environment right now.
Mark Fleming - So that should actually help slow the future pace of increasing premium rates, right? If more capital is coming in. So that is a good silver lining scenario. Okay, so let's say you own and operate a small portfolio of commercial properties. You're a mom-and-pop landlord. What would you do to manage these higher insurance premiums? And I suppose we're assuming you're in one of these higher risk markets.
Xander Snyder - Yes, exactly. Sure, and as you pointed out, really does kind of depend on how large that portfolio is, because if, just for starters, if you're a large institutional operator, you have a bit of an advantage, right? Because you have negotiating leverage, and you can go directly to the insurance companies and try to get them to come down on their premium rate. But, for those mom and pops, that's really rarely an option, so property owners that manage these smaller properties have decreased ability to directly negotiate with insurance companies. So, what else can they do? Well, one, you can always opt for higher deductible policies, which would lower premiums, but that only increases profitability today in exchange for increased risk of a loss after a future weather event. And that, of course, can be risky business.
Mark Fleming - Risky. Nice job, Xander. Now we're all doing the ‘80s references. It's not just me. This is very bad for our listeners. Risky Business, of course, the classic 1983 film starring Tom Cruise. Snuck it right in at the end. It's perfect. Just take those old records off the shelf. Okay, I will spare everyone the rest of that song, but it is a good one.
Xander Snyder - Yeah, you have to keep that streak going. So, other options for managing insurance can get a little bit more complicated. So, for example, you can have different layers of policy coverage, or there's even this thing called parametric coverage, which is a type of insurance that pays out when a certain type of weather event occurs in your area, regardless of the actual damage caused to a property. So, building operators can also try to offset that higher insurance expense by lowering expenses elsewhere on their income statement. So, for example, using less debt and thereby lowering their interest expense. These are all options that smaller mom-and-pop operators can attempt to implement.
Mark Fleming - All difficult decisions to be sure. It seems like mom-and-pop operators in disaster prone areas will bear the greatest brunt of these rising insurance premiums because they have the least ability to sort of adjust. It seems like expense management is going to be a key area of focus for property managers in the years to come.
Xander Snyder - I think that's absolutely right. And before we sign off today, I'll mention that listeners who are interested in more details about what the future may hold for commercial property insurance premiums and how they might pose additional operating challenges for building owners in this new environment, check out the commercial real estate section on the First American Economic Center where we've published about both of these topics recently. Thank you for joining us on this episode of The REconomy Podcast™. If you have an economics-related question you'd like us to feature in the future, you can email us at economics@firstam.com. And, as always, if you can't wait for the next episode, you can follow us on X. We are @XanderSnyderX for me and @MFlemingEcon for Mark. We'll see you next time.
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