Sharing the pain: Commercial real estate operators struggle getting insurance too

Non-renewals, denials, and ever-narrower coverage, just like at home

Michael Bryant, The Philadelphia Inquirer

Rising property insurance costs driven in part by relentless climate risks are causing problems for homeowners across the country, and may in some pockets of America push people into defaulting on their loans—triggering a stream of consequences.

What about commercial buildings? Don’t they sit right next door to homes? Why are we hearing so much about residential issues but nothing about insurance problems faced by the commercial sector? 

It's clear that climate effects aren’t the only reasons commercial office and hotel projects are seeing their costs escalate uncomfortably. Workers just aren't returning to offices in many US cities, and high interest rates have made financing projects an enormous challenge. It costs more to build or update buildings these days. Office loans, which make up about $740 billion of the $4.7 trillion in outstanding commercial mortgage debt, are particularly troubled.

Aug. 1, 2024, The New York Times.

But there's also a fascinating climate effects-insurance-default story that can be told about commercial real estate in America.

Rising insurance premiums connected to accelerating climate effects are causing headaches for commercial projects just as they do for homeowners. Eventually, these increasingly unsustainable costs will visibly contribute to ever-higher default rates for commercial loans—just as they will for residential mortgages. In fact, this may already be happening.

Skylar Romines knows about insurance issues facing commercial real estate operators. She's a former commercial insurance broker who represents CRE firms and developers in working with their insurers, and she's a good communicator. 

Speaking on a TreppWire podcast this week, Romines made clear that getting commercial insurance these days is as difficult as finding steady acting work. Something less than a third of applications arriving at brokers' offices even get picked up and read. Brokers "go in immediately looking for the risk," looking for ways to say no. They have quotas from their carriers limiting the amount of commercial real estate business they can write.

"As the client," Romines says, "We need to put our best foot forward. We're in competition—not with the insurance carriers, which is what a lot of people think—we're in competition with our industry peers." Often her clients can't get their policies renewed. They're just grateful to have their lenders "force place" coverage, no matter what that insurance costs. It's the "hardest insurance market that we've seen in 40-plus years," she says.

This sounds like the slush pile at a publishing house. Like getting into West Point or medical school. Like hoping for an invitation to a party you desperately want to attend. It's unpredictable and nerve-wracking. Romines says insurance is the fastest-growing expense line item in commercial real estate today. (MSCI quarterly data here.) 

Even once coverage is in place, Romines claims, it's usually not robust enough to meet lender requirements. Bananas, right?

"Everyone kind of agrees that [compliance] is probably well under 20 percent," Romines says, "Which is another massive liability in the market that nobody's really talking about." The banks apparently aren't checking their borrowers' homework very carefully, which will lead to surprises when extreme weather hits.

That weather is affecting a wide swath of the country in the form of wind, hail, and wildfire. "People forget sometimes that from an insurance perspective, it's not going to be 'hurricane,' it's wind and hail," Romines points out. The "hail belt" goes beyond Texas and Florida—look at Kansas, Oklahoma, and Nebraska. Sure, California has wildfires, but so do many other states. 

Romines seems to be hoping that this whole issue is cyclical and that insurance costs may moderate.

Indeed, optimism about commercial real estate reigns on the TreppWire podcast. Trepp as a company is part of the reporting structure for commercial mortgage backed securities. Last week, Trepp’s Chief Product Officer Lonnie Hendry talked about an office complex in Houston whose loan was securitized at a valuation of $162 million. Now the building is worth $26 million and is just 24 percent occupied. But don’t count Houston real estate out, Hendry says: “It won’t be six months, eight months, twelve months, you’ll start seeing office buildings in Houston sell for record prices.”

At any rate, it's not clear why the unpredictability and increasing expense of insurance will wind down. The climate isn't going to get better on any human-relevant timescale. Insurers are pulling back, writing fewer and narrower policies, and they clearly have pricing power. The only way to increase insurer enthusiasm and competitive zeal would be to reduce the risks faced by commercial real estate in the first place.

In the meantime, cracks in commercial loans are becoming visible.

There are short-term floating-rate giant-office loans that were made in the spend-quickly days of 2021-22 when the Federal Reserve loaned $100 billion to banks and asset managers. Commercial mortgage-backed securities were included in the list of eligible collateral for this federal money, and the market jumped to provide securitized baskets of commercial loans as vessels for the gush of borrowing.

Now default rates for these CMBS are climbing. Their operators' trouble is that the loans are coming due, they have to either pay them off or refinance, and in the meantime interest rates have gone sharply up—making failures far more likely.

Listen to John Devaney of United Capital Markets talking last month:

He's worried about regional banks' exposure to office loans, and he's convinced that crushing defaults are ahead. "The CMBS market is actually a disaster right now," Devaney says. He experienced large losses in the 2008 crisis, and he’s seeing signs of another round of setbacks.

Look at it this way: The unpredictable and sharply-rising cost of insurance is a significant additional burden for already-scrambling commercial borrowers. Homeowners in Florida are not the only ones having a tough time.