Incorporating Climate Risks into Mortgage Underwriting: A Necessity for Climate Considerations

From personal homes to commercial properties, the immovable assets form the pillars of our economic systems. However, the increasing severity and frequency of climate events such as floods, wildfires, and storms are threatening the very core of this bedrock. Studies (link here) have shown a direct correlation between climate risks and property values. The potential damages from such events can lead to a decrease in real estate prices, impacting the real estate financing process. But while the relationship between climate risk and property prices is established, there's an often overlooked facet in this dynamic - the appraisal process during mortgage underwriting.

Along the real estate financing chain, one term that is often heard but perhaps not fully understood is 'appraisal'. You might ask, "Why does an appraisal matter? Isn't it just another bureaucratic hoop to jump through?" To put it simply: No, it isn't. An appraisal, in the context of mortgage underwriting, is not just a hoop but a cornerstone of the entire real estate financing process. Here's why.

When purchasing property, the key question is: what's the property truly worth in the current market? An appraisal answers this question. It (aims to) provides an accurate, unbiased market value of the property in question. Without this essential valuation, both the lender and the borrower would be navigating the vast property market blindfolded, potentially leading to poor financial decisions. For lenders, it's a game of risk management. When a bank or a mortgage company lends money to homebuyers, they're making an investment, banking on the fact that homebuyers will pay them back. The property with that loaned money is, in effect, collateral. If lenders lend more money than the property's worth (because no accurate appraisal was done), they stand to make significant losses. It's not just lenders that benefit from accurate appraisals. Borrowers, too, have a stake in ensuring that they're not overpaying for a property. Overvaluation can lead to larger loan sizes, higher interest payments, and potentially getting caught in a property bubble. An accurate appraisal ensures that a buyer's investment is grounded in real market values, not mere speculation.

Not only in mortgage writing, the appraised value is also indispensable to the house insurance industry. Insurance, at its core, is about protection against unforeseen events. The appraisal value helps determine the amount of insurance coverage a property should have. An undervaluation might lead to underinsurance, where homeowners find themselves out of pocket after an incident, whereas an overvaluation can result in unnecessarily high premiums.

Recent tremors in the real estate market, driven by appraisal bias might be reminiscent of systemic risks that led to the real estate financing crisis. With the fact that transaction values are negatively affected by climate disasters, the question that looms is: are these appraisals taking into account the increasing risks posed by climate change?

There exists a compelling research opportunity to answer this very question. Consider this: By comparing appraisal values of properties located in climate-stressed regions with those in more climate-resilient zones, one could discern potential discrepancies in property valuation. To illustrate, imagine two properties - one situated in a flood-prone area and another in a climatically secure region. If appraisal methods neglect flood risks, they might inadvertently overvalue the property exposed to such risks, posing a heightened threat to lenders.

Beyond mere property values, it could also extend into unraveling the mindset of the experts - appraisers - in the appraisal process. When appraisers are informed about climate risks through updated tools like FEMA maps, does it recalibrate their valuations? Additionally, do actual climate events, such as recent floods or storms, alter their perceptions and subsequent valuation of properties?

Adding depth to this exploration is the socio-economic dimension. Often, socioeconomically marginalized populations live in areas more susceptible to climate risks. They have limited resources to deal with the aftermath of severe climate events. If their properties are misvalued due to climate risks, their ability to accumulate wealth through homeownership is further hampered. This cycle not only affects individuals but can also lead to systemic inequalities.

In essence, integrating climate considerations into appraisals isn't just about ensuring accurate property values. It's about preserving the economic stability of real estate markets, protecting lenders from potential losses, and safeguarding the financial futures of homeowners. By bringing awareness of climate risks into the appraisal process, we can mitigate potential future crises and shape a resilient real estate ecosystem for generations to come.