Insurance Premium Costs. What Apartment Investors Must Know

Property and liability insurance is a necessary expense. Recently, the costs of coverage premiums has become a topic of conversation among asset managers within the world of apartment investing. The question begs to be asked: are insurance premiums a real threat to NOI or just a terrifying figment of the imagination?

Before we dive in, let’s clarify that there are many reasons to have property and liability coverage on large multifamily investments. Apartment complexes are large, valuable assets that are funded by both a lender and investors. There’s a lot to lose for all parties involved. Having protection against loss of property and income in case of natural or other disasters is a key component of risk protection. In addition to risk protection, lenders will require there be a certain amount of property and liability protection to ensure full coverage of replacement value, as well as loss of income that could occur from damage to the property. Usually, the lender has the final say in what minimum coverage looks like.

Insurance premiums are a line item in every pro forma modeling of an apartment syndication. We often obtain several quotes based on the desired or required levels of coverage and that cost is incorporated into our underwriting model before we even make an offer on a property. Historically, those cost projections for premiums have been fairly reliable and stable. That is, until recently.

In the last 6 months or so, there has been unexpected, dramatic shifts in the cost of required insurance coverage. The cost increases are much more dramatic in select markets, but costs are rising essentially throughout all multifamily markets in a way that is affecting apartment syndications. This is occurring to the extent that these costs are now a new, unpredicted headwind for many apartment investment operators.

Background on Increasing Insurance Costs

Insurance carriers underwrite their coverage based on their risk exposure while also ensuring profit margins for themselves. And the cost associated with covering both of these aspects has risen due to several compounding factors.

First, the position of the insurance carriers is that there has been an increase in the frequency and severity of natural disasters. Some markets obviously are experiencing the higher end of the disaster cycles than other markets. We can look at the contrasts in severity of disasters on the Florida west coast vs the lack of severity in an inland market, like Atlanta. But, the fact that even Atlanta is seeing significant increases in coverage costs is a clear indication this argument doesn’t tell all of the story.

Another factor in the rising costs of coverage could also be attributed to the volume of litigations associated with those involved in the claims process. Whether it be the costs associated with litigating these cases or the payout of damages associated with the litigations, there’s no doubt that insurance carriers carry more cost risks on their end. To what degree these claims are genuine vs fraudulent may not matter, as the costs always get passed along to the customer (apartment syndicator operators).

A third factor in rising insurance coverage costs is inflation. There’s no doubt the cost of most items related to replacement and repairs is higher than it was 1-2 years ago. Even when inflation starts to cool, there are continued risks of price increases on items that insurances would need to cover in the event of losses. Again, these are passed along to the customer in the end.

Finally, some insurance carriers are leaving certain markets altogether. In their mind, the risk exposure to their profit margins are too great to continue to operate in certain areas of the country. Carriers may also feel uncomfortable with certain state or local regulations pertaining to their operation of coverage. Either way, this means there is less competition among carriers in the select markets. With less competition, we have seen prices increase because the carriers understand operators have very few choices for carriers.

Public Policy vs Insurance Industry

The impact of costly premium increases is not confined to just large multifamily assets. In fact, these increases are being felt by many business and property owners–especially in select markets. If there is an upside to that it is that politicians and local and state government officials are aware of this impact. There are proposals and legislative agendas in key markets, such as Florida, that could help alleviate the cost burden. This would be through clarifying regulations, increasing competition, and making it more favorable for carriers to operate in those markets. However, the implementation and impact of such agendas could still be at least a year away.

Real-world Impact for Apartment Investors

While this is not a fatal threat to most apartment syndication investors, it is absolutely a significant headwind. In less affected markets, these insurance premium increases can be 10 to 30%. However, in more exposed coastal markets, the increases can be multifactorial (2-3x). That is a very significant line item impact.

There is opportunity to pass along some of these costs to renters. However, most apartment syndications have already built into their underwriting a pro forma model of rent increases. These increases are the foundation for NOI growth and returning value to investors. Is there room for even more growth to absorb the increased costs of insurance premiums? Perhaps, in some assets in key markets that were bought with ample enough room for rent growth. However, many markets will simply not be able to absorb these costs into rents—especially the markets that are seeing more dramatic increases in premium costs.

What then? The simplest answer is that NOI will take a hit. It would be disingenuous for any apartment syndication operator to say there is no risk for decreased NOI from these shifts in costs. The question of how much impact is felt on investor value will vary from asset to asset.

Efforts to Mitigate Impact Insurance Costs

While this is a significant headwind, operators are already engaging every option they can to mitigate the impact of coverage increases on investors in these assets.

In some assets in select markets, again, passing along some of these insurance costs to renters may provide partial relief. However, this alone will not mitigate all the exposure—and certainly less so in the more affected parts of the country.

The second mitigation avenue is cost containment or reduction elsewhere on the P&L. Operators will need to get more creative about where they can conserve costs elsewhere. This could mean bringing certain tasks in-house or outsourcing depending on the benefits of each. Many costs are fixed, so the relief will be limited and dependent on each situation.

Lastly, there has already been a movement to property managers that offer a master coverage policy. Some property managers are large enough to leverage their scale to obtain a master policy. Operators can migrate a property to one of these property managers and be covered under their master policy. Significant savings could then be realized compared to the cost of coverage outside of these arrangements. However, even then, year over year premium increases can still be in excess of 20-30%.

One final word for investors in apartment syndications.

Yes, this is an unexpected headwind that has not been previously experienced to this degree in this asset class. Yes, it is a head wind for NOI growth. Could this affect an operator’s ability to deliver distributions to investors? Yes—especially if the operator is prudent enough to enter into cash preservation mode to protect against future risk. However, we would encourage investors to appreciate the long term nature of these investments.

Most investors understand apartment syndications are 5 to 6 year investments. These are not short term opportunities. This allows these investments to weather short term headwinds and still deliver returns for investors on the other side. I also think it’s important for investors to invest in opportunities that have preferred returns that accrue for investors. This ensures that, if your operator does not pay you to the annual preferred return, any shortfall is accrued and must be paid to you before the operator can share in free cash flow. This puts investors interests first and provides additional protection among the current headwinds.