A climate-risk adjusted housing market: introduce policy enforcing climate-risk disclosure in residential real-estate

By Alexander Carlo and Martijn Stroom

In July 2021, a severe storm and continuous rains caused rivers and streams to swell up and flood various towns in Germany, Belgium, Luxembourg and the Netherlands. In the city of Maastricht, the torrential rains caused the Meuse river to swell up to unprecedented levels. Consequently, approximately 10,000 people living in the most flood prone neighborhoods were asked to preventively evacuate their homes. The Dutch Minister of Infrastructure and Water Management, Cora van Nieuwenhuizen, and the Dutch Prime Minister, Mark Rutte, have stated that these extreme events are likely to be linked to climate change. Furthermore, scientists claim that we can expect events like this to happen more frequently in the future. Given the immense expected loss associated with flooding of an individual's property, it begs the question whether home buyers are pricing in the effect of flood risk on property value.

There is little evidence that housing markets fully incorporate information about flood risk in aggregate. Historically, waterfront properties come at a steep premium: although recently declining, the average premium to live at the waterfront in 2019 was still 35%. In the US, a Stanford University study revealed that being zoned in a floodplain does reduce property values by -2.1%. However, a full pricing of presence in a floodplain should affect property prices by -4.7% to -10.6% on average. In the Netherlands, after the previous 1993-1995 floods of the Meuse river, property values display this exact contradiction: value of the houses affected by the floods (see exhibit 2) are reduced by -7.4%, but those properties that are close to the waterfront benefit a 2.7% waterfront premium, thus only suffering a -4.7% decrease on average. In other words, buyers are not (fully) factoring in the cost of flooding damage risk, even after witnessing the fact.

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Exhibit 1: Observations in the sample alongside the Meuse river in the province of Limburg (the Netherlands). Properties in the sample were affected by at least one of the floodings in 1993 and 1995. The effect on the property values is deducted from transaction values of houses observed between 1990 and 2004. The sample contained 9,505 observed transactions, among which 246 concern houses located in a zone that has been flooded at least once, and 67 were surrounded by water during both events. Adapted from Daniel, Florax, & Rietveld (2009).

There are two main drivers that perpetuate this undervaluation of climate-related risk: subjective risk estimation and lacking information awareness. First, the buy-to-live buyers are currently under enormous pressure due to the enormous shortage in the housing market. This lowers the meticulous nature with pro’s and con’s are being weighed. In that context, ‘once-in-a-lifetime’ natural disasters such as historical floods are gladly dismissed as unlikely and thus an irrelevant factor for the property value. Only after a recent reminder that floods can occur and acknowledging the increasing probability in the future, does the relevance of flood risk damage for property value settle in. Shown by table 1, after the first flood in 1993, the property values only showed a negative yet insignificant trend (p=.35). It was not until the second, consecutive flood in 1995 occurred, that the necessity for people to account permanently for the risks associated with river flooding sunk in(/materialized).

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Exhibit 2: Estimates of flood effects on house prices before and after the floods. The first flood was in 1993, the second flood in 1995. There are no indications that the effect after the second flood gradually declined over time. Adapted from Daniel, Florax, & Rietveld (2009).

Second, perhaps unsurprisingly, in markets with better-informed buyers, the cost of fully insuring floodplain homes is better incorporated. More sophisticated commercial buyers discount flood zone properties more heavily (see exhibit 3). The discount for “business” buyers, which range from large corporations that own and rent out single family homes to limited liability corporations, is estimated at -6.9%, compared to -1.8% for non-business, buy-to-live buyers. The price penalty imposed by sophisticated investors seems to fully incorporate the expected loss associated with flood risk. This trend has also been identified in the pricing of other environmental attributes.

Martijn Flood1

Exhibit 3: Businesses discount flood zone properties. The flood zone discount for business buyers is estimated at −6.9%, compared to −1.8% for nonbusiness buyers (n = 5.65 million). Error bars denote 95% confidence intervals, and asterisks denote the statistical significance of differences between groups: ***P < 0.01. Adapted from Hino & Burke (2021).

How do we enhance awareness of climate risk among buyers, knowing that extreme events like floods are to happen more frequently in the future. Evidently, the market fails to accurately incorporate these risks for property value. Although informed-buyers do take the risk partially into consideration, buy-to-live buyers are mostly unaware until it is too late. In the US, the role of the government through real estate disclosure laws concerning climate and environment related risk has shown promising results. Exhibit 3 shows that in the states with the strictest disclosure laws concerning flood risk, the estimated flood zone discount is -4.1% compared to the nationwide panel of -2.1%. The Netherlands has this information readily available (any increasing climate-related risk for that matter) at a highly granulated level, ready to be included in valuation and transaction of (residential) housing properties. With a relatively simple disclosure obligation enforced by the government ensuring sellers to inform about the current and future climate-related risk, more accurate risk pricing can be achieved.

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Exhibit 4: Panel A shows the types of flood-related real estate disclosures required in each state. Three types of disclosures are considered: floodplain location (1), flood damage (2), and flood insurance (3). Panel B shows the estimates of the flow zone discount based on the types of flood-related real estate disclosure required. Adapted from Hino & Burke (2021).

Overall, the role that flood-related disclosure requirements imposed by governmental agencies in assisting buyers to be better informed on the relevant risk are crucial. Currently, the market fails to incorporate the potential climate-risk accurately, leaving potential buyers unknowingly exposed to unpriced climate risk. A market adjusting policy enforcing environmental disclosure in the real-estate sector must ensure that the housing market too reflects the increasing risk of climate-related events.

Read the (Dutch) public engagement on this subject by these authors:

NRC Handelsblad - Verplicht huizenlabel over risico bij overstroming (03-08-2021)

NRC Handelsblad - Klimaatverandering heeft nauwelijks invloed op huizenprijzen. Dat moet anders, vinden experts (03-09-2021)