New Research Shows: Climate Risk Affects Commercial Mortgage Delinquency
The frequency and intensity of natural disasters is rapidly increasing. The U.S. has experienced an average of 22 different billion-dollar climate disasters over the last three years, inflicting some $144 billion in annual damages (more here). Hurricanes are among the costliest natural disasters, representing more than half of all damages over the last decade (even though their share of climate events is just 11%). As areas prone to climate disasters have become more densely populated, casualties and economic damages have increased exponentially. The built environment is significantly exposed to natural disasters, with Hurricane Idalia serving as one of the more recent reminders of the damage a hurricane can inflict.
Not surprisingly, climate risk is more and more being recognized as an important factor by policy makers, the investment community, and financial markets. Due to the immobility of assets, the (commercial) real estate industry is especially vulnerable to climate risk, and there is an increasing interest to understand the impact of climate risk on the value of commercial real estate. Previous studies have largely focused on the residential market. The “commercial” part of real estate markets represents some $21 trillion in value. For commercial real estate lenders, changes in collateral value are only of partial importance. The ability of borrowers to meet their payment obligations is equally, if not more important.
In a new publication, we examine the impact of two major climate-related disasters – Hurricanes Sandy and Harvey – on the likelihood of delinquency in commercial real estate mortgages. The results show that both Harvey and Sandy led to elevated levels of commercial mortgage delinquency, with the impact varying by the extent of damage in the Census block group. For Hurricane Harvey, the effects are most pronounced in retail and office buildings, while Sandy had the largest impact on payment behavior in multifamily buildings. Panels A and B of Figure 1 indicate that the effect slowly dissipates for Hurricane Harvey, the impact of Hurricane Sandy seems to linger a little longer.
Interestingly, information provided through FEMA 100-year floodplain maps partially mitigates the effects, an indication that lenders incorporate flood risk information in the underwriting process. An analysis of potential mechanisms indicates a decrease in property income during the two-year period following the disaster for Hurricane Harvey, but no evidence of income effects for Sandy.
Figure 1 – Probability of Delinquency over Time
Panel A: Hurricane Harvey
Panel B: Hurricane Sandy
The findings in our paper have multiple implications:
First, understanding the historical impact of climate-related events on local financial markets is important for lenders and investors to accurately price in climate risk, but also for insurance firms in setting rates.
Second, for policy makers, understanding the relationship between climate risks and financial markets is relevant from the perspective of the projected increase in climate-related events, and the effect that may have on solvency of local businesses, the health of the local real estate market, and ultimately, the taxable base and its tax revenues for the municipality, county, and state.
Third, and quite practically, financial institutions need better, more accurate tools to assess climate risk exposure at the micro level. While our results show that the provision of climate-related information through the FEMA system seems to be quite effective in providing lenders with relevant data during underwriting – mortgages in FEMA-designated flood zones do not show elevated levels of delinquency – the precision of FEMA flood maps leaves something to be desired.
These considerations and more widespread access to frequently updated and improved climate risk assessment models are both relatively nascent but may have the ability to reduce the impact of climate shocks on the financial system, through more effective (or prudent) underwriting.