Impact of Climate-induced Weather Events on Property Prices: Are we cognizant of this?

“For 11 months – water is scarce; for one month – water scares us.” these were the words of a gentleman from Chennai. I was there for a conference on climate finance, and I remarked that though intensities might vary, this phenomenon is not limited to Chennai but other large cities in India, including other metropolitan cities. Mumbai, for instance, has faced flood events each year in the last 10 years – i.e., precipitation, which happens once every 10 years, is happening each year now. Precipitation and water scarcity attributable to climate change, will no longer be an aberration.

These events have started disrupting urban life, resulting in a decline in the intrinsic value and rental income of properties in certain areas in metropolitan cities. Gradually, this phenomenon challenges the conventional operations of housing lenders and mortgage bondholders, who will inevitably need to incorporate climate-induced physical risks – popularly divided into chronic and acute risks, into their decision-making framework. While the impact of acute risks such as storms, floods, and heat waves are sudden, the effects of chronic risks such as sea level rise and increase in temperature are gradual. Lenders and investors in the real estate sector presume that the financial impact of physical risks is still negligible in the near future. However, the recent increase in the frequency and intensity of climate-induced weather events suggests that these risks may have started threatening real estate assets, thereby depressing their value, especially in cities.

While floods and storms are restricting movements en masse and destroying real assets of households (cars, houses, etc.), lack of water is forcing people to use tankers. Moreover, heat waves in cities have adverse effects on the health of citizens. While the sea level rise risk is specific to coastal cities, a few centimeters of increase in sea level combined with a natural disaster such as a cyclone can worsen the flood situation in cities like Mumbai. All of these adversely affect property value through direct and indirect channels. Moreover, in India, the yield on property at 1-4%, is among the lowest when compared to peers. A low yield of real estate is meaningful when there is capital appreciation and rental income increases forever – a dangerous assumption made before the credit crisis that led to the global credit crisis. These weather-related events can substantially threaten or put a halt to this ‘ever-increasing price of properties’ party.

Another consequence could be the rise in the price of Insurance, or alternatively, insurance firms may withdraw their portfolios from locations exposed to climate-induced risks. Expensive or no insurance coverage indicates lower housing prices. Additionally, lack of insurance means a lack of liquidity in the housing market, finally culminating in massive risk for investors/lenders. Any serious physical damage without coverage can force borrowers not to pay EMIs, as the loan value could exceed the property value. It is noteworthy here that home insurance penetration is only ~3% in India. In sum, the existence of these large risk-induced uncertainties may result in chaos for the household and investors – as both can’t sell the house at a desirable price. Buyers would avoid certain locations– a systemic risk to the financial system as well as the general development of these locations.

Houses are long-lived assets that, at times, survive way longer than most of the capital-intensive projects. Therefore, investors with a long investment duration generally have an appetite for real estate. However, there can be a steep decline in investor appetite with the looming risk of climate change.  In the US, commercial banks that understand these dynamics, having the advantage of looking at the assets closely compared to bond investors, are offloading these loans to the capital market. Some corporates are also moving their facilities from these risky zones to other areas, although it is consuming their cash flows, but enabling them to avoid this significant future risk.

Relationship managers and event credit committee members ignore, likely unwittingly, these long-term risks to close the transactions. It is easier for executives to convince the risk committee that all the risks are considered as there is no historical precedent and risk is far-fetched in the future. Surveys conducted by the Reserve Bank of India (RBI) have found that several banks in India have started integrating climate risk into their underwriting and risk management processes, though they are still in an early stage. Also, home insurance penetration is extremely low in India exposing lenders to the physical risks of climate change. Although home insurance is set to rise in the coming decades the insurance period is very short, as short as one year, compared to a loan tenor (5 to 30 years). As insurance premiums of properties are likely to increase or are no longer insurable in certain locations, the value of houses as collateral could decrease or be worthless for lenders.

It is important to recognize the physical risks of climate change and price them appropriately or simply sell at-risk assets in exchange for climate-resilient properties. Lenders and investors must collect a wide range of climate-related information (e.g. local weather data, asset vulnerability, and hazard exposure) in the underwriting process and monitor them regularly. Regulators must closely watch this risk and, in their supervisory capacity, monitor how banks are considering this risk in their internal risk calculation.

Views are personal and do not represent that of the authors’ employers.

Disclaimer: “Any views or opinions represented in this blog are personal and belong solely to the author and do not represent views of CFA Society India or those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity, unless explicitly stated.”