As we have discussed in recent issues of Fixed-Income Sector Views, the commercial real estate market is feeling the stress of limited transactions, challenging lending conditions, and hybrid work models. We are also seeing signs that long-term cost-related factors are affecting the fundamental backdrop in commercial real estate operations and valuations. Our CMBS sector team highlighted that expenses are rising faster than revenues in multifamily properties, which is pressuring debt coverage and valuations. Insurance has become a significant component of a property’s operating expenses. Moody’s recently reported that since 2017 property insurance costs have escalated at an average annual growth rate of 7.6 percent nationally, far exceeding the historical growth rate of 2–3 percent. Certain markets such as California, Texas, and the Sunbelt states have experienced an annual growth rate above 10 percent. There are several factors driving the increased cost of property insurance. The number of $1 billion+ natural disasters has steadily increased over the last two decades, resulting in higher losses. The rising cost of construction materials and labor, and the resulting higher replacement costs, have exacerbated the magnitude of claims. Property and casualty insurers and their reinsurers have exited some high-risk markets, and some smaller, non-diversified insurers in markets such as Florida went insolvent or were placed on regulatory watch.
Owners of all property types will feel the impact of rising insurance costs. Apartment and hotel owners cannot immediately pass on those costs to their tenants and guests, if at all, because rents or room rates are set based on what the market will bear. Office owners, already under stress from increasing vacancies, will struggle to absorb these costs in an environment where tenants are able to demand material concessions. In markets that have experienced disproportionate casualty losses, owners may also find that some coverages are simply not available at any cost, which poses significant problems when mortgage lenders require owners to provide full recourse for any uninsured losses.
While we have not drawn any red lines because of these circumstances, as we go through our due diligence process we are mindful of the rising cost of insurance, especially in regions that are more vulnerable to climate risks and other natural disasters. We do not expect the pressure points on costs to moderate soon, so we carefully consider the impact of the cost escalations on returns, adjust cap rates, and stress collateral appropriately.
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*Assets under management is as of 3.31.2024 and includes leverage of $14.5bn. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, and GS GAMMA Advisors, LLC.