Flooding and its Impact on Commercial Real Estate Values

Catherine Morgan
Wednesday, 20th January 2016

December 2015 saw the the wettest year on record since 1902 in the UK with storms Desmond, Eva and Frank generating what the Centre for Ecology and Hydrology (CEH) called “extraordinary” hydrological conditions, leading the UK's rivers to discharge more water into the ocean during one day than ever before.  

Extreme weather events impact on property values. Although the real estate sector is increasingly helping to tackle the causes of climate change through better energy performance and the use of sustainable materials for example, it is not paying enough attention to the risks posed to individual assets from single extreme weather events such as storms, floods or droughts.

A recent Urban Land Institute (ULI) report suggests that the number of extreme weather events has doubled globally since the 1980s to an average of over 800 over year in the past decade. In addition, the report estimates that the direct financial losses to reinsurance companies caused by these weather events through damage to real estate and infrastructure now amounts to US$150 billion per annum globally, having tripled in a 10 year period. Although damage arising from storm damage and flooding will only represent part of this, the numbers illustrate the scale of the problem.

Can we quantify how flood damage affects real estate values?  While clear risk assessments are undertaken by investment houses on commercial purchase decisions, no simple alogorithm exists to discount values on buildings potentially affected by flooding. But values will be affected. The risks from extreme weather events are either not being integrated into real estate investments, or valuations are being addressed indirectly by adjusting rents, yields or costs. Valuations will take into account vacancy rates and rental values when valuing potential future cash flows using Discounted Cash Flow techniques. Both will be affected if commercial buildings are on flood plains. While vacancy rates are likely to rise as a result of flood risk assessment, rental values are most likely to fall - and neither situation is welcome in an era of economic recovery. There is evidence, however,  that investors will simply adopt a yes-no approach to investment decisions based on flood risk assessment (if there is a risk of flooding don’t buy it) rather than try to discount.  That in itself will affect the markets view of value in the long term.

While most investors realise that extreme weather events (and the susceptibility of value to these events) are now an increasing reality, there is space for work to try to quantify these aspects of value, although there is now evidence that more complex models are beginning to be developed in this regard.  As our understanding of the complex interactions between natural hazards and real estate dynamics continues to develop, what is clear is that if current climate projections transpire, there will be financial implications for the real estate sector.  The ramifications for building insurance premiums and the insurance industry remain to be seen.

Edward Trevillion BSc., PhD (Heriot Watt)., PhD (Nottingham)., MRSC, TD

Before moving to Heriot Watt as Honorary Professor of Real Estate Investment and Finance Edward was Head of Real Estate Research and Strategy at Scottish Widows Investment Partnership (now part of Aberdeen Asset Management). He was responsible for directing all aspects of property research at SWIP to underpin investment decisions and identify new areas for investment. He has significant experience in property market modelling techniques and is particularly interested in developing adaptive models that take account of changing property market structures. His current research interests are centred around behaviour in commercial property markets and the use of non-linear models to forecast behaviour in the market.

He continues to publish in a variety of journals and magazines and regularly lectures at seminars and to real estate students at Heriot- Watt University. He is an external examiner for the Masters Programmes in Commercial Property and Planning and Development in the Department of Town and Regional Planning at the University of Sheffield and is Chair of the Scottish Government Working Group on the Private Rented Sector in Scotland. He is a member of the Investment Property Forum’s research steering group and the investment committee of the Scottish Episcopal Church.