When will Miami's real estate market reflect climate reality?
Timing is the billion dollar question
Asset prices reveal investor perceptions about an investment’s mix of risk and reward. All else equal, as risk rises, asset prices fall; and as potential reward rises, asset prices rise. We would therefore expect growing climate risks in vulnerable places, including Miami, to cause real estate values to fall. But it’s mostly not happening.1 Why?
What we really want to know is whether the reasons home prices have remained high are rational or irrational. Irrational reasons are those that suggest housing prices in climate vulnerable communities are not properly factoring in climate risks. Rational reasons, on the other hand, suggest property values in Miami and other climate vulnerable places accurately reflect the balance and timing of risk and reward. If rational reasons predominate, housing is properly valued or close to it. If irrational reasons predominate, there’s likely a housing bubble in climate vulnerable markets.
In my recent piece, Are Miami real estate buyers crazy, or am I?, I offered several possible explanations for why real estate in Miami, arguably the American city most endangered by climate change, has not seen significant value declines. (This list leaves out the sixth one, about climate change actually not being a big deal, which was on the list just so I could ostentatiously reject it.)
Do people not think decades ahead, preferring to enjoy life in the present?
Is a crash in property values so far off that applying a discount rate to projected future rents actually supports these high property values?
Are housing prices boosted by the fact that Florida’s political leaders are actively backstopping the home insurance market?
Does the fact that Miami hasn’t experienced a powerful hurricane since Hurricane Andrew 30 years ago contribute to a false sense of security?
Or is the planetary discontinuity of climate change simply too vast to fully internalize, even for many who know climate change is real?
Reasons #1, #4, and #5 are all irrational in slightly different ways. Living for today and not worrying about the future (#1) may be peaceful and chill, but in the real estate market in the climate change era it will be an expensive life philosophy. The false sense of security created by Miami’s 30-year stretch without a direct hit from a major hurricane (#4) is standard-issue recency bias, a classic analytical error of the kind unsophisticated investors make regularly. And failing to grasp the implications of a major structural shift (#5) is a defining quality of the “dumb money” in any market. These reasons are all irrational because they overlook climate risk rather than factoring it in.
This leaves #2 and #3 as possible rational explanations for why Miami home prices are still so high:
Is a crash in property values so far off that applying a discount rate to projected future rents actually supports these high property values?
Are housing prices boosted by the fact that Florida’s political leaders are actively backstopping the home insurance market?
These are rational, or perhaps quasi-rational, reasons that market participants might be willing to pay high prices for climate vulnerable Miami real estate. Today I’m going to look at #2, and in another upcoming article I’ll examine #3.
When a future outcome is known, people eventually start to behave as if its already happening. But it depends how far in the future. If a state announces that in 2 years it’s going to install fast internet in Ruralville, which currently only has dial-up, home values in Ruralville will spike higher today. But if it announces it’s going to install broadband in Ruralville 20 years from now, home prices mostly won't react for a while. It's just too far away.2
Similarly, we know if a real estate market crash were going to happen in 60 years it would matter a lot less to today’s valuations than if the same crash were going to happen in 4 years. But what if it were 30 years away? How about 18? 7? Intuition is good, but to really understand this we need a model.
I built this simple one in order to ground my thinking in math.3 Let’s start with the following optimistic scenario:
You have $500,000 in cash to invest and one option is to buy, as an investment property, a house in Miami.
Your plan is to rent the house out for 20 years and then sell it (the model makes the unrealistically optimistic but simplifying assumption that there will be no rent lost in periods of vacancy).
Net operating income (NOI) for the house would be $30,000 in year 1, a 6 percent effective yield on the $500,000 purchase price (a “6 cap”). (NOI is rent revenue minus operating costs, which includes insurance, repairs and maintenance, and property taxes.)
NOI will grow by 3 percent annually for the 20 years you plan to own the house.
In light of constrained liquidity and other risks of physical real estate, you set your discount rate at 7.5 percent, meaning that’s the annual return you would need to earn for the investment to be worth it.
As the discounted cash flow analysis shows, this optimistic scenario has a net present value (NPV) of $589,611 on an investment of $500,000. That means the optimistic scenario returns more than the 7.5 percent discount rate, making it a good place to invest the $500,000 if you believe the future will roughly match this scenario.
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Now let’s look at a less optimistic scenario in the same model to get a feel for its sensitivity. Specifically, let’s make the following changes, which reflect slowly increasing weather intensity and periodic extreme weather events:
Unlike the optimistic scenario in which net operating income rose 3 percent every year for 20 years, in this scenario after rising 3 percent annually for the first five years you own the house, net operating income growth slows to 1.5 percent annually in years 6-10, is flat (zero growth) in years 11-15, and declines 1.5 percent in years 16-20.
Everything else stays the same as the optimistic scenario: starting NOI of $30,000, intended holding period of 20 years, 7.5 percent discount rate, 6 percent cap rate.
The net present value of the less optimistic scenario is $479,027, less than the $500,000 cash you currently have, meaning its return over 20 years is less than then 7.5 percent discount rate. If you believe the future will fairly closely resemble this scenario, then the investment property’s risk/reward proposition, while not awful, isn’t quite good enough.
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Finally, let’s run a fairly pessimistic scenario. Let’s make the following changes, which reflect a future where climate risks become gradually more salient among buyers in the Miami real estate market:
In this scenario, NOI increases 2 percent annually in years 1-5, and is flat in years 6-10; it then declines 3 percent in years 11-15, and falls 5 percent annually in years 16-20.
Everything else stays the same: starting NOI of $30,000, intended holding period of 20 years, 7.5 percent discount rate, 6 percent cap rate.
The net present value of this fairly pessimistic scenario is $393,654, obviously a bad investment when you start with $500,000. If you believe the future is likely to unfold like this scenario predicts, real estate in Miami would be a poor investment.
The most important insight from the model is that small deviations from conditions of steady growth in perpetuity can seriously compromise the value of a house, even if they don’t begin for several years. This is clear when the less optimistic scenario results in a net present value that’s $110,000 less than the optimistic scenario even though it has the same growth trajectory in years 1-5, net operating income is still growing in years 6-10, and NOI doesn’t start declining until year 16.
From a different perspective, it’s somewhat surprising in the fairly pessimistic scenario, where net operating income declines 3 percent per year in years 11-15 and 5 percent per year in years 16-20, that the NOI in year 20 is still more than $21,500.4 Even after NOI declines 10 years in a row, the house still produces considerable income, which is somewhat counterintuitive.
There’s another important angle on this, however: these scenarios leave out that factors other than declining rents that can cause net operating income to fall. Remember, NOI is rental revenue minus operating expenses, which includes 1) home insurance, 2) repairs and maintenance, and 3) property taxes. In a warming world, all three of these costs will increase.
Home insurance costs will rise because intensifying weather increases the risk of damage and insurance companies will raise rates to reflect that. If a home sustains damage for which insurance companies have to pay out, insurance for that home will rise even more in subsequent years – and that’s if insurance is available at all. Insurance will also reduce coverage with higher deductibles, lower caps, etc. This will create an unseen cost in the form of increased risk of out-of-pocket expenses from extreme weather events.
Repairs and maintenance will get more expensive as houses need to be stronger to withstand more intense heat, rain, and wind. The financial logic behind such investments includes that homeowners whose homes avoid serious damage in storms may enjoy less expensive insurance for longer than those who need insurance payouts to repair seriously damaged homes. As seas rise and weather grows more extreme, homeowners will also need to invest in upgrades like sump pumps to manage water.
Property taxes are the primary way local governments raise revenue, and in the years ahead the city and county governments in Miami will need more revenue than ever to upgrade infrastructure, fix damaged public properties, and pay for their own rising insurance costs.
This part of the story is crucial because it means net operating income can decline even if rents are rising, and we just saw how much falling NOI affects the value of a rental property.
I did the math on the impact of higher operating costs on home values several months ago in Climate change and housing bubbles. It’s too long to quote in full, but here’s the takeaway:
We established Home A is worth $3,994 per month. When Person A bought Home A, only $1,300 of the total amount was taxes and insurance, but now taxes and insurance have increased to $2,000. That means the mortgage can now only be $1,994, rather than $2,694, in order to stay at the established fair market value of $3,994 per month. If we assume the next buyer of Home A will also put down 20% and take a 30-year mortgage for the rest at 3.5%, how large a mortgage can the next buyer take out and still end up with an all-in cost of $3,994 per month?
The answer, via this spreadsheet model, is $444,054. Borrowing $444,054 at a rate of 3.5% fixed over 30 years comes to a monthly payment of $1,994. Adding the 20% down payment to the mortgage amount gives us the new fair market value sale price of Home A: $555,067.
Thus, when Home A’s home insurance premium increased from $300 per month to $1,000 per month, the value of Home A fell by $195,000, from $750,000 to $555,067. If the insurance repricing occurred in the first few years of ownership, Person A would see all of their equity wiped out and be left underwater, owing more on the home than it was worth – this despite their large $150,000 down payment.
Rising operating costs of homes is a big, big factor in how well they hold their value.
These models are useful but, unfortunately, can’t predict the future and therefore can’t tell us the most important things we want to know: How rapidly will climate impacts continue to worsen? When and where will powerful hurricanes make landfall? How much damage over baseline will the combination of higher seas and more intense storms inflict on vulnerable cities like Miami?
Models also can’t tell us how residents will react to a damaging hurricane. Will recent arrivals pick-up and leave for somewhere more fun, flooding the housing market with inventory in the process? Will the many foreign investors who have their wealth parked in Miami condos rush to sell before the market crashes? Or will everyone hold steady, help their neighbors, donate to those left homeless, and work to rebuild the city? If the next big storm sees the latter outcome, what will the storm after that bring? We can’t know for sure.
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Returning to our thought experiment, if the housing market where you live were going to collapse – say prices fall by at least 60 percent – 50 years from now, how long would you wait before selling your home to avoid losing the equity you’ve built? What if the housing collapse were going to happen in 20 years? 8 years? 2 years?
How long do you think other people would wait before selling their homes? How might their calculus affect your approach?
For a long time now, most of it with a stable climate, real estate in coastal cities has been a good investment. In today’s world, with temperatures steadily increasing, real estate in the most vulnerable cities is extremely high risk without the realistic possibility of high returns.
Miami faces a particularly dire long-term future. From a recent Destabilized Saturday Edition, here are the factors that make Miami especially climate vulnerable:
Very low elevation, nearly the entire city is lower than 10 feet above sea level (“With just three feet of sea-level rise, more than a third of southern Florida will vanish”).
Miami sits on limestone, which is so porous water can come up through it from below, and thus renders sea walls ineffective (“Imagine Swiss cheese, and you’ll have a pretty good idea what the rock under southern Florida looks like”).
Exposure to Atlantic hurricanes, like Hurricane Andrew, which devastated the city, along with much of South Florida, in August 1992.
Unusually high concentration of real estate at low elevations along the coast.
Key nuclear energy facility, Turkey Point Nuclear Plant, sited on the edge of Biscayne Bay and exposed to storm and rising seas, which climate writer Jeff Goodell calls “as clear a picture of the insanity of modern life as I’ve ever seen.”
Drinking water sources at risk of salt water contamination.
Sewer treatment infrastructure that’s highly vulnerable to sea level rise and storms, including more than 100,000 septic tanks.
Less diversified economy (real estate, entertainment, hospitality), which is arguably more likely to see downward spiral-triggering population outflows after destructive weather events than other cities.
High levels of climate denial and wishful thinking, among both regular people and, especially, the state’s Republican leadership.
Zero percent income tax, and, more broadly, a low-tax, low investment ethic befitting a state whose executive and legislature have been fully Republican controlled since Jeb Bush was elected governor in 1998. Both the revenue magnitude and the mindset are the opposite of what’s needed to build physical resilience.
An already shaky home insurance market, which has problems that go beyond the inherent vulnerability of Florida homes to climate damage, and in which the state of Florida itself is now the insurer of last resort for those who can’t get policies written in the private markets.
The many ways these factors reinforce and amplify one other, including that higher sea levels mean a future hurricane’s storm surge will do more damage than if the same storm hit when sea levels were lower.
Some places in the U.S. have already gotten crushed by climate change. We’ve seen devastating wildfires in inland California, extreme heat in parts of the Southwest and Pacific Northwest, flooding in Eastern Kentucky and Iowa, and hurricanes in Houston, Louisiana, Puerto Rico, New York City, and elsewhere. Other places have dodged the worst of the possibilities, and Miami is on that list. Tragically, this state of affairs won’t last.
Whenever it ends, hopefully not for a long time, those who own real estate in Miami may regret that they didn’t sell when they had the chance.
There is evidence – see here, here, and here – that climate change is already having an effect on the value of homes directly threatened by climate impacts, and other evidence that giving home buyers information about climate vulnerability can dissuade them from buying the most at-risk homes. At this point, however, the changes are small and mainly affect homes with the most exposure to climate impacts.
Both scenarios assume that before the news comes out the market has no expectations of broadband coming to Ruralville.
To do a discounted cash flow analysis you need, well, cash flows. But note that the model applies to homes people live in as well as to homes people rent out to others. The net operating income (NOI) input in this model is rent collected minus operating expenses (taxes, insurance, repairs and maintenance), which for a homeowner is equivalent to rent avoided by virtue of owning a home minus the costs of owning the home (taxes, insurance, repairs and maintenance).
Though the net present value of that NOI today is a lot less.