The Environmental Defense Fund (EDF) has estimated that properties in flood-prone areas in the US are highly overvalued. This places low-income homeowners and the municipalities they live in at risk of catastrophic losses, unless policymakers and stakeholders take action to reflect the risk in house prices and costs are borne by those responsible.
- A study by the non-profit organisation EDF found that US homes exposed to flood risk are overvalued by up to $237 billion.
- The overvalued properties tend to be located in counties with no flood risk disclosure and in areas with less regard for climate risks.
- The study compared four different scenarios of the consequences of possible stakeholder and policy decisions, especially for low-income homeowners and localities heavily dependent on property taxes.
An increase in atmospheric moisture from climate change and global warming has resulted in heavier storms and more severe flooding, causing more economic destruction. This can be exacerbated by high-speed winds and rain caused by hurricanes. While insurance companies have widened their coverage for hurricanes, they do not include flood cover.
In the US, every building with a federally backed loan that is located in a Special Flood Hazard Area must have flood insurance. Congress created the National Flood Insurance Program (NFIP) to share the risk of flood losses and to reduce flood damages by restricting floodplain development.
US properties are overvalued
According to the EDF study, published in Nature in February 2023, flooding is the most harmful of the natural hazards caused by climate change across the US. The researchers estimated that properties exposed to flood risk may be overvalued by a total of $121-237 billion, depending on the discount rate, or the interest rate borrowers expect to pay, being used: a 3% discount rate, for example, would result in an overvaluation of $187 billion.
Over 14.6 million properties are located in the so-called ‘100-year flood zone’ or areas facing a 1% probability of flooding annually, where anticipated annual damages could exceed $32 billion. The study estimated that the number of these properties could rise by 11% as the frequency and severity of flooding rise due to climate change, in turn increasing the average annual losses by 26% by 2050.
There are concerns that the increased risk of flooding and related losses have not been factored into house prices, which results in artificial inflation of house prices. Ignoring the risk of flooding and related damages could also lead to further development in flood-prone zones, contributing further to a bubble in these areas.
“Increasing flood risk under climate change is creating a bubble that threatens the stability of the US housing market. As we’ve seen in California in the last few weeks, these aren’t hypotheticals and the risk is more extensive than expected—and that risk carries an enormous cost,” said Dr Jesse Gourevitch, a postdoctoral fellow at EDF and lead author of the study.
What are the potential impacts of overvalued housing prices?
A major concern resulting from ignoring mitigation actions in high-risk areas is the continued construction of new properties and further inflation in housing prices. As flooding occurrences continue to increase, NFIP premiums are also likely to rise, but these will be shared by all homes covered by the scheme, and hence all taxpayers as NFIP is a federal scheme. This effect results in the socialisation of costs – the wider sharing of costs than just by the people who are responsible for them – rather than internalising or limiting them to the region or location where they occur.
The EDF study found that overvalued properties usually were in coastal areas that have poor flood risk disclosure laws and where there is less concern about climate change.
A further finding revealed that low-income households were at greater risk of losing equity in their homes from a drop in prices. Property price deflation can also reduce the assessed value of homes, in turn lowering the tax revenue from these properties for the municipalities in which they are located.
Indeed, the study found that for each level of overvaluation (0-5%, 5-10%, and so on), a greater percentage of homes belonged to people in the lowest 20% of household median income for that region.
Devaluation from flood risk can reduce the assessed value of homes, and negatively impact municipalities that are heavily reliant on property taxes for revenue. Property value declines from natural disasters can occur a lot quicker than they do from economic declines, for example, which increases the likelihood of sudden declines in tax revenue for the municipalities affected by flood disasters.
The impact of flood risk on housing prices by region will likely depend on the size of the bubble, or overvaluation, and the frequency and time period over which they occur. Mitigating these impacts will depend on the response by policymakers and the various stakeholders in the mortgage industry.
“There is a significant amount of ‘unknown’ flood risk across the country based solely on the differences in the publicly available Federal flood maps and the reality of actual flood risk. As that unknown risk is realised, there are significant implications for both individual property values and the health of the larger housing market,” said Dr Jeremy Porter, a senior research fellow for First Street Foundation and one of the co-authors of the study.
How does the EDF suggest flood risk should be mitigated?
The EDF considered four scenarios to show how stakeholders and policymakers can tackle climate change-related flood risk, and their impacts. They were: ‘business-as-usual’, ‘market crash’, ‘damage reduction’, and ‘soft landing’.
In ‘business-as-usual’, lower risk reduction and higher total costs, combining with a lack of reflecting on the potential risk in housing prices, and wider spreading of costs related to flooding, such as higher NFIP premiums, across all homeowners, regardless of whether they are in a flood-prone zone. Stakeholders ignore the financial effects of flooding and, if no additional public finance mitigation plans are put in place, the housing bubble in flood-prone areas inflates further.
‘Market crash’ differs from the above scenario if there is a greater reflection of flood risk in the value of a property and, rather than being spread system-wide, there is a higher localisation of costs. Of flood risk and higher internationalisation of costs. Here, flood incidents cause a rapid shift in public and stakeholder perceptions, leading to a sudden decline in prices, increase in insurance premiums, mortgage defaults and losses to homeowners and local governments.
‘Damage reduction’ is achieved when there is a greater reduction of risks and total costs, although flood risks are not properly reflected in property prices and the system bears more of the resulting costs. While in this scenario there is potential to reduce the level of overvaluation of properties, there are still risks of continued building and development in flood-prone zones.
The ‘soft launch’ scenario combined increased risk reduction, lower total costs, a better reflection of flood risk in house prices, and higher internalisation of costs. Policy and stakeholders make decisions that incentivise homeowners on mitigation actions, while gradually differentiating high flood-risk properties by their insurance premiums and mortgage rates.
“The risk of overvaluation is higher in lower-income communities. For many people, their most valuable asset is their home. We need policy approaches that improve the transparency of climate risk in markets while also providing increased support and protection for frontline communities,” concluded Dr Carolyn Kousky, associate vice president at the EDF and co-author of the study.