The three ways climate change will erode real estate values in vulnerable areas
Physical damage, increasing costs, and decreasing demand
*I use “homes” and “real estate” interchangeably in this post. Not only are the categories overlapping, but the same climate change-driven dynamics apply to both.
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Climate change is going to erode the value of climate vulnerable homes and homes in climate vulnerable places1 - but how, exactly? In thinking a lot about this question, I’ve identified three buckets of value-erosion mechanisms.
Uninsured physical damage - Uninsured (and under-insured) physical damage from a flood, hurricane, wildfire, etc. destroys value as well as structures.
Increasing cost of ownership - As the cost of insurance, repairs and maintenance, and property taxes rise, a home’s value will fall.
Decreasing market demand - As awareness of the implications of climate change grows, demand for climate vulnerable homes will decrease, and fewer potential buyers erodes value.
(Note: In applying these concepts, when some or all of a home’s value is lost to uninsured physical damage we have to be careful not to later double-count that lost value as a repair cost. The value is either lost when the destruction occurs or it is lost when money is spent to rebuild what was destroyed, but not both. It’s simpler to view the value as lost when destruction occurs, in part because that value is gone even if no money is ever spent to rebuild.)
Let’s look closely at each of the three mechanisms.2
Uninsured physical damage
The value destruction from uninsured physical damage is the most straightforward of the three. If I buy a house, don’t insure it, and it gets leveled by a tornado - hopefully with me safely elsewhere - the value of my ownership interest in the house rapidly goes from whatever it was to zero. The land on which my destroyed house once sat will retain some or all of its value, but the value of the house is gone. I may choose to rebuild or not, but either way I’ve lost the value of my home.
A subcategory here is under-insured homes. If your home is destroyed - completely or partially - the proportion of the destroyed value you get paid out by your insurance company depends on the specifics of your policy. The many examples and nuances are beyond this scope of this post, but what’s worth mentioning here is that as insurance premiums rise, insurers will try to keep prices down by incrementally reducing coverage. Higher deductibles, more carve-outs, lower caps, and more excluded categories of damage all tactics insurers will use to keep premiums down.
Insurance coverage isn’t binary, it operates on a continuum. The net effect of this approach by insurers will be to leave more risk on homeowners’ shoulders. There will be lots of stories in the years ahead about people whose homes are destroyed by extreme weather events discovering their insurance, which they thought was adequate, isn’t sufficient to rebuild.
Increasing cost of ownership
The big cost categories of owning a home are 1. insurance, 2. repairs and maintenance, and 3. property taxes. Climate change is driving all three higher.
Home insurance costs are rising because climate change increases the risk of physical damage and the magnitude of the associated insurance payouts. As I noted above, the higher cost of insurance includes both higher monthly premiums and reduced coverage in the form of higher deductibles, lower caps, more exceptions, etc., all of which leaves more risk on the shoulders of property owners.
Repairs and maintenance are getting more expensive because houses need to be more durable (fireproofing, wind reinforcements, hurricane-proof windows) and more strategically designed (better drainage systems, pumps) to protect against worsening weather extremes before they happen. Houses are also incurring greater damage because of more frequent and climate-intensified weather events. Some of the damage may be insured, but much of it either isn’t covered or is small enough that it doesn’t make sense to file a claim.
Property taxes should already be rising due to climate change, but mostly aren’t yet. They will inevitably rise in the future because local governments will have to make significant infrastructure upgrades, fix public property damaged by storms, and pay for their own rising insurance and repairs and maintenance costs. Property taxes - as well as borrowing in the bond market backed by property taxes - will be the primary source of the needed funds.
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In Climate change and housing bubbles, I looked at two homes, one climate vulnerable and one climate durable, that both cost $750,000 and have identical monthly costs (property taxes = $1,000/month, insurance = $300/month). Using a financial model to understand what would happen if the climate vulnerable home saw its insurance premiums rise from $300 to $1,000 per month, I found that its value would fall by $195,000, or more than 25 percent.
The logic is simple: if there were two equally desirable homes but one of them required you to spend $700 more each month than the other, which would you be willing to pay more for?
Decreasing market demand
The mechanism through which climate change will most dramatically erode home values is market demand. As the risks of climate vulnerable homes become clearer, demand will fall; and with the supply of vulnerable homes steady or rising and demand falling, prices for these homes will decrease, often substantially. Put another way, in the future fewer people will be willing to buy risky homes in climate vulnerable areas at today’s prices or anything close to them.
A foundational insight in this analysis is that climate vulnerability is not currently a meaningful factor in the median home buyer’s calculus. It will be, but it isn’t yet. With few exceptions, homes today are priced as if they are climate durable, regardless of their actual degree of vulnerability.
As hot places continue getting hotter - especially across the Sun Belt, from the Carolinas, Georgia, and Florida to Arizona, Nevada, and parts of southern California - people’s desire to live there will wane. As hurricanes grow more intense and destructive, our collective enthusiasm for living in their most frequent paths will shrink. As water supplies dwindle, the prospect of building a life in a dry climate will lose its appeal. Home values follow demand which follows desire. As the desirability of climate vulnerable areas and homes decline, so will home values.
As the planet continues heating, rains intensify, seas rise, floods grow more damaging, and wildfires threaten more people across more of the year, home values in climate vulnerable places will fall. Homes will incur physical damage, the cost of ownership will rise, and the appeal of climate vulnerable places will fall. The net effect will be to crash housing markets in climate vulnerable areas. And unlike the popping of the cyclical asset bubbles we’re familiar with, when climate change crashes a housing market, it will stay crashed.
Today, markets are pricing homes across the U.S. as if they’re equally climate durable. The scenario individuals and families absolutely need to avoid is buying a climate vulnerable home for a price that assumes durability.3 Many people will nevertheless do precisely this, and the decision will financially destroy many of them.
That’s the risk. The opportunity lies in buying climate durable real estate in places that will become relatively more appealing as climate change worsens. These are places where the cost of ownership will increase at a normal rate, insurance premiums will be steady, property taxes won’t need to increase as much, and, crucially, where the attractiveness of living there will rise, rather than fall, over time.
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We can’t predict precisely when the climate repricing of housing markets will begin, but this summer has already seen a series of unprecedented weather extremes, including surface level ocean temperatures in the mid- and upper-90s around Florida, deadly flooding around the world, the lowest level of winter ice formation in Antarctica on record, wildfires across vast stretches of Canada, and much more. One suspects climate vulnerable places will see their housing markets crash the same way Hemingway’s Mike went bankrupt in The Sun Also Rises: gradually, then suddenly. But it may depend on the nature of the vulnerability, and that’s a topic for another post.
Most homes in climate vulnerable places are climate vulnerable, along with certain homes in areas that are generally climate durable. For example, homes in the flood plains of rivers in New England and the upper Midwest are highly vulnerable to more intense rainstorms, even though their regions are climate durable.
One could argue that the Increasing costs of ownership bucket is really just a subset of Decreasing market demand. Demand may be decreasing because of rising costs, the argument would go, but it’s ultimately still a change in demand. I’m willing to mostly concede the conceptual point, but I think it’s nonetheless worth distinguishing decreasing demand driven mechanically by a higher cost of ownership (buyers may want the house as much as ever, but can’t afford to buy it when insurance is $7,500 per year) from decreasing demand resulting from a more subjective, context-aware, and forward looking sense that a given house in a particular region isn’t as appealing a place to live as it used to be.
Holding rather than selling a climate vulnerable home you already own is also a recipe for financial disaster, if not quite as jarring or dramatic as buying in shortly before the decline begins.