Owning a home or purchasing a commercial building is no longer as affordable as it once was, which is one of the overriding trends impacting the real estate insurance market. While it has been tight the first half of 2022, rising interest rates may slow the overheated real estate sector a bit, further stabilizing it at a macro level.
It is true that one of the major changes in the last two years in real estate is the exponential costs of rental properties. Consider that in the U.S., a living wage of $25.82 per hour is needed to afford the average rent of a two-bedroom apartment, or $21.25 to afford a one-bedroom apartment. The living wage requirement is much higher in states like California, Hawaii and New York. It is nearly $40 per hour in California.
While rentals have risen across the board, home values continue to increase as well. The National Association of Realtors recently indicated that the median price for a home in the U.S. is $416,000, a 13.4 percent increase from 12 months prior. That median price hurts first-time homebuyers, who are faced with high demand and low supply. This forces them to make quick decisions without having all the information needed to finalize a purchase decision, such as a full home inspection. After all, homes are only on the market for a period of days or even hours in some communities.
New property development is gradually increasing as the impact of COVID dissipates. However, inflation is reducing the incentive developers have to construct new commercial, and in some cases residential, buildings. The result is a skew toward non-admitted policies in an excess and surplus (E&S) market.
Indeed, it is an interesting time for the residential and commercial real estate market. Yet there are headwinds that suggest a gradual softening may be coming.
The impact of interest rate increases on the residential market
Interest rates have been so low for so long, that the definition of “high” interest rates needs adjusting. During the week of August 8, the average 30-year fixed rate was at 4.99 percent, compared to 2.77 percent 12 months prior. While a 2.22 percent jump in one year is significant, a 4.99 percent rate is actually “normal.”
Historical mortgage rate data available from Freddie Mac indicates that interest rates are getting lower each year. Consider the average rate in 1971 was 7.54 percent. In 2020, it was 3.11 percent. The long-time average for 30-year mortgage rates from 1960 – 2020 is over 7 percent. So even though today’s mortgage rates are hovering around 5 percent, they are still historically affordable.
The low rates common to the last decade allowed homeowners to afford a second home as an investment and/or to rent for additional income, increasing demand. Even the historically modest increase in interest rates should have a cooling effect on these types of purchases, which is healthy for the market. Rising interest rates above 5 percent will further level out home prices over time, tamping down demand and helping homebuyers.
Commercial market is challenged by higher vacancy rates
Before the COVID pandemic, the commercial market had a positive net absorption rate, but the remote working movement changed everything. Now more space is being vacated. Companies in particular are leaving Class B, or older properties, and moving to Class A, or newer properties, if they require commercial office space at all. These newer properties often provide new amenities, high-tech features, and contemporary office designs.
Meanwhile construction costs remain extremely high, often increasing by double digit percentage points each month. Finding available contractors and scheduling time for a buildout or new construction is nearly impossible in many markets, with businesses having to schedule out two years or more in advance. The new construction pipeline in the commercial segment has shrunk consistently every month since March 2020.
Professional liability trends
The Professional Liability Insurance market was generally in a hard period before COVID and that continues today. Fortunately, the impact on real estate has been less than other industry verticals. Multi-family units such as townhouses, condominiums and the like are very difficult to place. Underwriters are requiring agents and brokers to provide specific details like location, amenities, revenues, property manager details and history, whether any renters are behind in their payments and other potential exposures before coverage is provided.
An MPL application can be used in conjunction with specific real estate supplements. Many underwriters are also requiring information about commissions and property values as well.
Financial institutions are increasingly investing in multi-family residential real estate more so than commercial, largely because of higher demand due to the remote working environment employers offer.
Be aware of fair housing requirements
Property managers should have their entire staff prepared for the impact of testers who are sent out to large residential complexes. The testers are there to ensure Fair Housing policies are protecting residents. They will ask questions of not just property owners but landscapers and service personnel, and one “wrong” answer could lead to a discrimination lawsuit.
Such lawsuits are a large and increasingly common exposure in the real estate space. A maintaining factor for EPLI coverage is employee count, including the number of full-time versus part-time employees. All coverage must be extended to those contractors or there could be a gap in coverage. All local and state policies and laws regarding fair housing must be followed. The exposure is higher in areas like California, New York and Dade County, Florida where the environment is favorable for claimants. Prices for this coverage is high and is largely based on property value.
Always consider cyber
According to the FBI Internet Crime Report, nearly $2.4 billion was lost in 2021 to Business Email Compromise (BEC) or Email Account Compromise (EAC) attacks. The exponential rate at which malware attacks and extortion claims occur explains why Cyber has become such a hard market with limited capacity and rising premiums. This impacts the real estate market as well since all employees need training for phishing and social engineering attacks so digital doors are not mistakenly opened for hackers.
Both commercial and residential real estate clients are challenged by the desire for more automation. In the commercial market, building access through digital card readers and automated thermostat access for heating and cooling are two significant exposures for cyberattacks. The possibilities are even greater in residential real estates with garage door openers, doorbells/cameras and appliance accessibility all available through an internet connection. Cyber Insurance must always be considered as part of a real estate portfolio with software updates critical to reduce vulnerabilities.
Full disclosure is needed with all types of real estate policies
Capacity, pricing, and exposure are all positively affected when policyholders disclose all available information. There are several types to highlight:
EPL coverage costs will vary when multistate operations are part of a risks profile. The state or county a risk is in will have a direct impact on pricing when underwriters evaluate the exposure. Different deductibles will also be applied based on the location and type of operation.
When evaluating the exposure of a home inspection operation, underwriters look for overall experience or inspector training history, their location, the likely quality of inspections (Google Reviews) and more. Digital inspections are becoming more common and drones can be used to assess “hidden” or difficult to reach vantage points. These emerging exposures can be addressed with personal injury and property damage coverage extensions.
For residential policies, insured parties who have any ownership in rented properties must disclose such information. Once again it is incumbent on brokers and agents to communicate this to clients. On the commercial side, agents and brokers will need to disclose their clients’ renter information and status of rental payments or risk higher exposures and coverage gaps.
Sellers much disclose information related to:
- Large pieces of vacant property
- Waterfront property
- Easements and access for other neighbors
Due diligence period before a purchase is finalized
This is an important time for residential and commercial insurance clients. Once the offer and letter of intent is developed, prospective buyers have a limited time to inspect the property and confirm that the sellers are providing full information. Environmental issues like past flooding (weather related or not) are of particular interest. Buyers must ask their inspectors questions and support a complete inspection that would disclose any issues.
Final recommendations for brokers and agents
- An E&O form covers many professional services on the residential side, but brokers and agents should also include an extension for tenant discrimination when that exposure is present.
- All employees working for a property manager need to have an accurate and up-to-date understanding of state and local protocols to provide an extra layer of protection. That property manager also must account for all employees in his or her policy.
- Have an accurate account of all full time, part time, independent contractors as well as any seasonal or volunteer employees by state so underwriters can properly evaluate the exposure and price accordingly.
Contributed by Casimer Daniewski, Vice President, Real Estate, H.W. Kaufman Group; Connor Cahill, Broker, Professional Liability, Burns & Wilcox
This commentary is intended to provide a general overview of the issues contained herein and is not intended, nor should it be construed, to provide legal or regulatory advice or guidance. If you have questions or issues of a specific nature, you should consult with your own risk, legal, and compliance teams.