Real estate valuations: Don’t forget insurance

Commercial real estate is in the news – and not necessarily for the right reasons. Chronic issues with shrinking leases due to a slow ‘return to the office’ environment paired with rising interest rates, a constricted financial market and shrinking fair market valuations, are combining to create nightmares for some office owners.

And then there is insurance. In the same manner that lenders are cutting refinancing, the property insurance market for assets exposed to catastrophic perils (California earthquake, ‘tier-1’ wind, high hazard flood) and convective storms (hail, tornadoes) has also seen rate increases well in the high teens. This is due to a material lack of reinsurance capacity and five years of underwriting losses that equated to a nearly US$27bn (€25bn) loss in 2022 for the property and casualty industry. According to the Insurance Information Institute, the combined P&C loss ratio was in excess of 105.8%, which is 6.3% worse than 2021. In other words, for every dollar the US property-casualty industry took in, they paid out US$105.8. Not an optimal business model.

With interest rates rising, why would investors put money into reinsurance when they can receive a guaranteed rate that is risk free? Reinsurance is required by virtually all insurers to backstop their balance sheets. When insurance companies are being charged between 30% and 70% more for lower limits of reinsurance while being required to take materially higher retentions (deductibles), the cost is passed on to the owner of the asset.

Also, the replacement cost for commercial real estate has increased due to inflation, thus underwriters are requiring the correct values to know their true exposures. As values increase, so do premiums because insurance is calculated on replacement cost not fair market values. Many owners in recent years ignored the need to increase values because they were trying to avoid paying more in costs. Unfortunately, the reinsurance market put an abrupt end to that practice, and the result can be very draconian endorsements that limit the recovery to the specific value initially reported or possibly with a slight margin for additional recovery.

Two real-time examples of massive claims due to under-reported values are in the hospitality and industrial sectors. In both cases, the reported values were between 100 and 200 times below the actual claim amount. This means insurers that underwrote the risk not only failed to charge an appropriate premium, but also will have their ‘position’ wiped out despite not believing there was any exposure.

Many insurance programmes that cover catastrophe-exposed assets are structured like a jumbo commercial loan with multiple insurers each taking a piece of the stack. Given the nature of catastrophic risk, hundreds if not thousands of assets are exposed. The reinsurance market backstops all of this, thus Hurricane Ian (one of the most costly losses in the past five years) increased costs, not just to tier-1 assets, but to west coast owners because they are all within the same bucket of catastrophic insurance.

Why does this matter? Nearly all lenders require catastrophic insurance, particularly for ‘full replacement cost’ of assets located in tier-1 wind areas. Loans that were negotiated prior to 2023 may have requirements for the insurers providing coverage to have S&P ratings of AA or A, which may limit the amount of available insurance at deductible levels that insurers will no longer provide. If the debt is commercial mortgage-backed security, it is almost impossible to renegotiate the insurance provisions of the loan, placing a massive economic burden on owners.

Gone are the days where insurance provisions contained the ‘commercially reasonable and available’ provisions that gave borrowers room to amend the loan if the insurance did not exist. Given how constricted the lending market is, it is doubtful that borrowers will have much leeway when it comes to negotiating insurance coverages.

What can be done? Delivering third-party-verified replacement costs while modelling for expected earthquake and wind losses will go a long way in providing lenders with certainty that the assets are correctly protected. With lenders themselves also modelling replacement costs and forcing increases, we advise on getting out ahead by providing them with the scientific methodology supporting more appropriate wind and earthquake requirements.

Increasing the ‘all other peril’ deductibles beyond the ‘old school’ US$25,000 per occurrence and working with insurers to provide an indemnity agreement is another strategy to leverage. This essentially guarantees that the owner will be responsible for paying the larger deductible while the insurer simultaneously allows certificates to be issued at the deductible level required by the lender. This strategy has been approved for more than a decade and has proven to be a way to eliminate the ‘dollar trading’ that attritional losses cause.  As loans are being negotiated, request the insurance requirements and consult with an insurance broker to determine what can be accomplished and at what price.

Alexandra Glickman is senior managing director and global practice leader for real estate and hospitality at Gallagher