Rising costs ripple through private real estate

Debt costs have risen sharply, but the inflationary environment has also had an outsized effect on other costs for managers.

Over the past year the real estate industry has grappled with rising interest rates, the impact of which is yet to fully be realized. Debt costs have risen sharply, but the inflationary environment the rate hikes are supposed to be curbing has also had an outsized effect on other costs for managers.

In the US, inflation peaked last year at a yearly rate of 9.1 percent in June, just a few months after the Federal Reserve began its tightening cycle. It has since come down to around 4 percent, according to the US Bureau of Labor Statistics.

During PERE’s conversations with managers in the past couple of months, managing rising costs in the inflationary environment has emerged as a key issue facing the US real estate industry.

“Insurance has become a huge issue across all property types. We are seeing increases of two to three times when renewing insurance coverage on assets in certain coastal markets,” says Tom Shapiro, president of GTIS Partners. “Property taxes are also rising as municipalities need to fill in budget holes. Rents are moderating now, and not keeping up with cost increases any more. So landlords’ net income is getting squeezed from both sides.”

Insurance costs are a key concern. Increases are partly driven by inflation and interest rate hikes – similar to most investors, insurance company portfolios have been hit by the denominator effect – and partly by severe natural disasters like wildfires and hurricanes. Most managers PERE spoke with say insurance costs had at least doubled and, in some cases, quadrupled.

“Revenue growth is slowing, yet our expense inflation isn’t necessarily,” says Steve Gullo, head of residential at CBRE Investment Management. “As a result of this dynamic, in the near term, we will be prioritizing opportunities where we can achieve our return objectives through operations and business plans that allow for additional revenue generation.”

The increase in insurance costs is most acute in the multifamily sector. Data provider Trepp found property insurance costs per unit for multifamily properties in Florida, Texas and California grew 37 percent, 43 percent and 35 percent on average between 2020 and 2022.

Specific markets are driving that increase. In California, San Francisco saw year-on-year increases of over 30 percent in property insurance in both 2021 and 2022, according to Trepp. Miami saw a 32.6 percent increase last year, primarily because of Hurricane Ian. Multiple managers said rising costs had taken deals off the table in Florida, with one saying its pipeline had halved in the state.

Insurance strains

The cracks in the insurance market are starting to show. State Farm and Allstate, two of the largest homeowner’s insurance companies in the US, stopped issuing commercial and individual property insurance in California earlier this year. State Farm cited “historic increases in construction costs outpacing inflation, rapidly growing catastrophe exposure, and a challenging reinsurance market,” as reasons for the decision.

Meanwhile, property taxes in key gateways are also rising. Residential properties in New York saw taxable value increases of 3.1 percent in 2022 and 7 percent in 2021. Commercial properties saw increases of 5.2 percent and 8 percent in the same window, respectively.

In Chicago the assessed taxable value of all property rose 8 percent year-on-year in 2021, and another 6.5 percent in 2022. One manager tells PERE the property tax issue “has killed Chicago” for them. “We no longer do apartment deals.”

Many managers interviewed expect markets in Republican-led red states and cities to be more favorable from a property tax perspective compared with ‘blue’ ones, as the latter continue to increase the burden.

While office has been the epicenter of the discussion around rising debt costs, multifamily is the most affected by rising costs in insurance and property taxes.

“The landlord pays all the expenses,” Shapiro explains. In some markets, rents have risen to as much as 40 percent of tenant income. “If people can’t pay more, you can’t drive more rents. The math doesn’t really work that way.”

Another reason is a lack of supply. The US is short of as many as 6.5 million homes, but property tax increases make it harder to hit targeted yields on construction cost. “I think the effect of it is that there will ultimately be less development that pencils,” says one manager. “The irony is that ultimately will increase the cost of housing.”

Mitigating the risks

Sound cash management and ample reserves can help property owners to cover higher costs, but there is little they can do to bring costs down.

One way to mitigate the risks of higher costs is to insure properties at the portfolio level.

Maryland-based firm FCP does this. “By marketing a larger portfolio with a higher total insurance premium and geographic diversification, insurance carriers’ risk-return trade-off looks more attractive than a one-off transaction,” Esko Korhonen, founding partner at FCP, says.

As costs continue to rise, owners could be hit with more. ESG regulations, like New York’s Local Law 97, are implementing fines for real estate owners that do not comply with emission reduction targets beginning next year. Other cities in the US are planning similar laws or have already implemented them, such as Washington, DC and Boston.

Like with property taxes, there will be a bifurcation of jurisdictions that impose stricter ESG regulations versus looser ones. Private real estate managers will have to figure out which locales fall into each camp.