Why mispricing the risks of Sea Level Rise could prove costly
Homeowners in Florida’s coastal areas are increasingly factoring in the risks of sea level rise, or SLR, caused by climate change. According to a new paper by Wharton real estate professor Benjamin Keys and Wharton doctoral student Philip Mulder, home sales volumes have declined in at-risk markets, indicating that homebuyers are becoming more worried about SLR. However, home prices remained high even as sales fell, suggesting that sellers were unwilling to cut their prices and may be less inclined to believe that SLR will affect their properties. And mortgage lenders, whose portfolios are protected from flood risk by federally supported flood insurance and securitization, did not tighten their credit standards in SLR-exposed areas.
These disconnects between SLR risk and housing markets assume wider importance as 42% of Americans live in “a coastal shoreline county,” according to the paper, titled “Neglected No More: Housing Markets, Mortgage Lending, and Sea Level Rise.” The fact that home prices are slow to reflect new information about SLR risks suggests that continuing polarization around climate science, and the federal programs that insulate lenders from flood risk, could lead to distorted investment into more risky coastal regions, the paper noted.
To the extent that the markets do reflect SLR risks, the impact is uneven, disproportionately hurting vulnerable sections of the population. “It seems as if the communities that have the highest poverty rates are feeling the effects of this most dramatically and quickly,” said Keys. “The declines that we observe in transaction volumes and in prices are exacerbated in high poverty areas.” Places that have above 15% poverty have had a much larger decline in their prices, said Keys.
If Florida’s housing markets have to correctly reflect SLR risk, they would show up in lower volumes and prices, and also in higher borrowing costs than those in markets without such risks. “So, there are some distributional concerns that we have to think about as well,” said Keys. “If we raise the price of borrowing on the coasts, how do we help the people in low-income communities adapt and adjust?”
Communities in Jeopardy
More broadly, more than one million properties on the coastal Florida market are at risk of chronic inundation due to SLR, according to projections by the Union of Concerned Scientists that the paper cited. “The ‘most liquid’ parts of Florida – in that they are most likely to be underwater by 2100 – have increasingly illiquid housing markets,” the paper noted.
“It seems as if the communities that have the highest poverty rates are feeling the effects of this most dramatically and quickly.” –Benjamin Keys
Keys and Mulder studied housing and mortgage market trends in Florida between 2001 and 2020, and found increased recognition of SLR risk after 2013 – a period when record-breaking storms and increasingly dire scientific forecasts made SLR risk more salient. Home sales volumes in coastal Florida markets across different levels of SLR exposure followed similar trends over the housing market boom, bust and recovery. It was only in 2013 that volumes in more-SLR-exposed areas began to decline even as their less-exposed counterparts continued to grow. The paper’s estimates suggest that about 16,500 fewer home transactions took place from 2013-2018 among the 187 census tracts most exposed to SLR.
While sales volumes fell, prices took longer to wake up to the SLR risks. In fact, prices in high-risk tracts increased along with those in low-risk tracts until 2016, the study found. In what it described as a “lead-lag” relationship between volumes and prices, prices in SLR-exposed tracts began to fall only after 2016 for a relative decline of 5%-10% by 2020. Even those price declines are just about a third to a quarter of the size of the decline in volumes, said Keys.
Significantly, lenders don’t seem to show sensitivity to changing SLR risks as both all-cash and mortgage-financed home purchases in Florida have similarly contracted, the study found. “The government-sponsored enterprises Fannie Mae and Freddie Mac don’t price that type of risk,” said Keys. (Fannie Mae and Freddie Mac buy home mortgages from lenders and sell them as mortgage-backed securities to investors.) “They don’t differentially price regional risk, so the price that you pay for a mortgage in Iowa is the same as the price that you pay for a mortgage in Las Vegas. There is no differential pricing based on which state you’re in or whether you’re close to the coast or far from the coast.”
The risks for mortgage lenders in Florida’s SLR-prone areas are undeniable. Those places will be exposed to more storm surges and high-tide flooding that would inundate roads and infrastructure grids, Keys noted. “At some point, there may be more pressure to say it doesn’t make sense for us to keep supporting lending, additional development and new construction in these coastal communities that are at risk. We need more data and more modeling to understand the appropriate risk-based price. That appropriate risk-based price would be reflected in higher borrowing costs in these areas for taking on this additional risk.”
‘A Natural Place to Start’
Keys embarked on the study because he was motivated to do research on risk-based pricing. The 2008 financial crisis and its aftermath underscored the importance of such research for him. “Coming out of the financial crisis, we had this realization that in many ways, housing markets and mortgage markets were not accurately reflecting the possibility of a downturn,” he said.
Keys wanted to look at other dimensions of risk, and “climate-related risks came to mind,” he added. “Florida is the place where the rubber meets the road.” The state has “so much exposed coastline and so many exposed properties that it seemed like a natural place to start to look for evidence of these patterns and trace them out.”
“Coming out of the financial crisis, we had this realization that in many ways, housing markets and mortgage markets were not accurately reflecting the possibility of a downturn.” –Benjamin Keys
According to Keys, “This paper is tracing out the path of the market response. It’s very intuitive that starting from where we are today to some later point in the future, properties that are extremely vulnerable to sea level rise are going to see their values diminish over time. Eventually, a property that’s underwater in the absence of mitigation (say, by way of infrastructure improvements) or change will be worth zero. Once it’s literally underwater, it’ll be inaccessible and uninhabitable.”
Prices of Florida homes with SLR risks may not necessarily move in a linear path from today to that future point, Keys noted. “If anything, we would think that markets can unravel very quickly, and expectations play a key part in driving prices,” he said. “A big part of the value today of owning a property is its future value. The question for us was, is the market already reflecting this expectation of some future inundation date, around which there’s a lot of uncertainty?”
Uncertainty also exists over how quickly sea levels will rise. “The scientific consensus is that sea levels will rise over the next 50 to 100 years quite substantially, probably between two and six feet,” said Keys. “The question is, how does an asset market like housing incorporate this information?” The study found that Florida’s housing markets did incorporate that risk from 2013 in sale volumes, but it took longer for it to show up in price declines.
A Hot Real Estate Market
Those declines in Florida home sales volumes and prices would have perhaps seen a secular downward trend, but the coronavirus pandemic has recently introduced a demand rush. “Data from this summer has shown that a lot of properties are being purchased in some of these coastal areas. Anecdotally, it seems as though people have been scooping up beach houses.”
Despite that recent spike, “the long-run secular trend only points downward in terms of value, unless there’s significant investment taken in terms of seawalls, drainage and other infrastructure to try to protect some of these some of these low-lying areas,” Keys said.
“The scientific consensus is that sea levels will rise over the next 50 to 100 years quite substantially, probably between two and six feet.” –Benjamin Keys
The impact of SLR risks in Florida’s coastal communities is not isolated. A Federal Reserve study points to a similar pattern of behavior with recurring wildfires in California causing declines in house prices. Keys also pointed to concerns about heat levels in Phoenix, Arizona, and some cities in the Southwest. “There have been some discussions about what share of days are going to see over 100 degrees by 2100, and that may be a factor in terms of demand for housing,” he said. “Who’s going to want to live there when it’s over 100 degrees every day of the year?”
Departure of optimists?
The way Florida’s housing markets factor in SLR risk is because of “the shrinking and eventual departure of ‘market optimists’ from the market,” the paper noted. “For supply to equal demand, ‘optimistic’ sellers and ‘pessimistic’ buyers would need to agree on how the threat of sea level rise affects the present value of at-risk homes.” Among other factors, partisan divides on the risks of climate change and “the behavioral forces of myopia and optimism” may be causing homeowners in SLR-exposed areas “to make irrational assessments of their risk,” it added, citing research by others.
Yet another factor is a phenomenon of housing markets “that’s often underappreciated,” Keys said in a recent interview with Wharton Business Daily on Sirius XM (Listen to the podcast at the top of this page). “Prices are not necessarily the market clearing mechanism in the way [they are with other asset classes] because houses are durable, long-lived goods. If you don’t want to sell this year, you can wait. What we’re seeing [in Florida’s SLR-risk markets], I think, is a lot of folks deciding to wait and say, ‘Well, it’s not the right time to sell.’” Meanwhile, the lower property values will also eventually show up in a declining tax base in communities with SLR risks, and that will mean reduced ability to invest in infrastructure improvements to mitigate climate risks, he added.