Real Estate and Flood Risk

Piet Eichholtz

Ancient wisdom in real estate has it that three things matter in the business: ‘location, location, location’. The exact same thing holds for climate risk, as last week’s events in Germany, Belgium, Luxemburg and the Netherlands illustrate. The devastation of river floods in the area was terrible, but the television footage also showed the huge differences in exposure between properties and infrastructure close to the river bed and assets located on higher ground, even as the distance between them was small. While properties close to the water suffered grave damage, or even complete destruction, higher-up location were not affected at all.

A location close to water, be it a river, a lake or the sea, has traditionally been regarded as a good thing, enhancing the value of the property. However, as evidence of increasing climate risk is mounting, this is likely to change, as the risk of floods increasingly outweighs the benefits of a nice view and the comforting sound of moving water. For real estate investors, a key question is whether that change is still to come, or already happening.

In a recent paper (Addoum, Eichholtz, Steiner, Yönder, 2021), we investigate whether flood risk is already visible in real estate prices, even at locations which have not (yet) experienced a flood. We look at exposure to floods from the ocean, for locations in the United States. Ocean-borne flood risk mostly comes from hurricanes, so we first explore whether hurricanes have become more frequent, severe and/or damaging. The answer on all three issues is ‘yes’. The first graph shows three lines: the upward sloping line depicts the Sea Surface Temperature (SST) anomaly, the degree to which the upper layer of the ocean is colder or warmer than average. A warmer upper layer implies more evaporation and more potential energy for hurricanes, so an increasing SST implies that hurricanes get likely more severe. The bars show the number of years since the last mayor hurricane, and the downward sloping trendline shows that hurricanes become more frequent. They also become more frequent at higher latitudes.

Fig 1. Sea Surface Temperature Anomaly and Hurricane Frequency, US East Coast

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The second graph shows what this means for commercial real estate prices. We study the effects of hurricane Sandy, which hit New York in the Fall of 2012. It was the first time a hurricane of such magnitude his the US East coast that far north, so it was unlikely that real estate markets had anticipated the risk, implying that closeness to the water had positive value until the event.

We look at effects on pricing in New York and Boston, and we add Chicago, as a placebo test. The graph is based on a regression analysis in which we compare the value of proximity to the water before and after the incidence of the hurricane, while controlling for a wide range of other value-relevant factors. One can clearly see that the value of water proximity was stationary in the decade before 2012, for all three cities we study. But that changes in 2012. After Sandy, the proximity to water got a big negative value shock. This is not very surprising for New York, which had just experienced the effects of a devastating flood firsthand. It is perhaps more surprising that we observe a similar, but smaller shock for Boston (10%, against 22% for New York), which had not been hit by a hurricane at all. This price effect suggests that the market is now anticipating such an event. In Chicago, meanwhile, nothing much changed after 2012. If anything, the value of water proximity even went up. This underlines that the price effects for New York and Boston are indeed due to the harsh wakeup call of Sandy, and the market’s sudden awareness concerning ocean-borne hurricane risk.

For real estate investors, this implies that their portfolios may already be experiencing price effects from climate exposure, even if that exposure has not yet manifested itself in the locations of the real assets they own. Climate risk has become a key component of portfolio risk for real asset investors.

Fig 2. Commercial Real Estate Pricing and Proximity to Water (New York, Boston, Chicago)

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