When Nature Defies Models: The Unseen Impact of Hurricane Otis on Real Estate
Unpredictable climate events in vulnerable areas affect property insurance everywhere, here's why
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A hurricane that no person, or model, predicted could be so bad
Earlier this year Southern California faced something which they had not seen since 1858, a hurricane barreling toward them from over the Pacific Ocean. At one point a potent Category 4 hurricane (and projected to get worse) cities and residents braced themselves for disaster. Fortunately, just before making landfall in Baja California, the cyclone quickly weakened into a tropical storm and by the time it hit San Diego and Los Angeles, was relatively mild in its impact. “Relative” of course, in this case, as compared to how devastating the storm could have been had it landed at full strength. Hilary’s impact was most severe in Death Valley National Park, which saw a two-month closure due to flash flooding. The storm also led to widespread power outages and flight cancellations, affecting thousands of residents and travelers. All told, a little over $500 million of damage was done.
About 2 months later came Hurricane Otis, another Pacific Hurricane that took a sudden turn in its severity just prior to landfall, but this time the hurricane took a turn for the worse. On the evening of October 22nd in the Mexican resort town of Acapulco, tourists were told not to worry. Most weather models predicted that, at worst, Otis would be a weak tropical storm. Vacationers turned in for the evening expecting an uneventful night. In the overnight hours of October 22nd-23rd the storm rapidly intensified and, by 3 AM local time, it had reached Category 5 status just 55 miles off the coast of Acapulco. Upon landfall, the Hurricane was still roaring, with one station recording gusts of 204 MPH. By the time the sun rose over Acapulco on the 23rd, 5-star resorts that were left standing had no remaining windows. The devastation caused ~100 fatalities and >$20 billion in total damage. Otis went down as the strongest Pacific Hurricane on record to make landfall, and the costliest hurricane (Pacific or Atlantic) in Mexico’s history.
So, what went wrong?
To understand what went wrong, and why Hurricane Otis ended up being so much worse than expected, it’s worth briefly examining how Hurricane prediction models work. At a super basic level, a bunch of computers use math to predict a range of outcomes for the storm: most importantly its strength and direction. These forecasts, which are primarily done by the National Hurricane Center, are then passed along to meteorologists and local officials to inform residents and plan accordingly to mitigate damage.
Like any model though, the predictions are only as good as the assumptions and inputs on which they’re built. Bad data, or bad assumptions, will result in incorrect results. We have a saying for this in finance: “garbage in, garbage out.” In the case of Hurricane Otis, both the data and the assumptions were garbage. First, and perhaps less critically, the computer models failed due to a dearth of data. Experts, including National Hurricane Center's Michael Brennan, have highlighted the East Pacific’s sparse instrumentation, like ocean buoys and radar, which forces forecasters to rely heavily on satellite data for storm assessment. This limitation was evident in the initial underestimation of Hurricane Otis. Following Otis's formation on October 22, models predicted a peak intensity of merely 45 mph and a trajectory moving away from the Mexican coast. Secondly, the models are built on assumptions about how quickly and vigorously storms may gain or lose strength. One of the most critical assumptions is ocean temperature. Due to significant increases in ocean temperatures over recent years, hurricanes and tropical storms have become increasingly volatile, accelerating or decelerating at a greater pace than they did historically.
But remember, the computer models provide a range of outcomes with various paths and severities. Like in the case of Hurricane Sandy above. What made the catastrophic events in Acapulco so horrifying, was that not a single individual forecast predicted the storm’s actual path. In other words, Hurricane Otis broke the model. Even in their wildest imaginations, scientists did not think the outlier path that the hurricane took was possible. Therefore, Acapulco, along with 80 other municipalities in Mexico’s Guerrero region, were woefully underprepared and the result was utter devastation.
Even more worrisome? Among what insurers call “CAT” (or, Catastrophe) events which include earthquakes, tsunamis, floods, and hurricanes; the modeling around hurricanes is the most sophisticated, the others are much harder to predict.
How does this affect your real estate? One word: reinsurance
The sad fact is, in addition to the tragic human toll Hurricane Otis took, the events in Acapulco also have a deep financial impact on real estate owners and investors nationally and, indeed, internationally. Even in areas with little perceived climate risk. When I say a deep financial impact on real estate investors, that is to say almost everybody; it’s important to remember that many sovereign wealth funds and pension funds have a high allocation to real estate. This is where nations’ wealth and working-class citizens’ retirements are invested.
One might think, because it’s a logical assumption to make, that when a black-swan event such as Hurricane Otis occurs, property insurers increase their premiums. After all, they’re businesses that need to protect their profits. What most people probably wouldn’t expect, is the degree to which this impacts property values as a whole due to a number of confounding factors.
First, insurers have no way to quantify this tail-end risk. To reiterate what we stated in the last section, Hurricane Otis literally broke hurricane prediction models. Combine this with the fact that insurance companies still don’t have any sophisticated method of predicting other CAT events such as earthquakes and floods, and it becomes very difficult for them to evaluate how much total possible damage they are insuring annually. To solve for this, they prudently underwrite their insurance extra-conservatively; which means they make cautious estimations of how much total damage they may have to insure, and they pass this cost along to their customers.
But this only affects real estate in vulnerable areas, like in hurricane zones and on fault lines, right? Wrong. Which brings the second compounding factor.
The most valuable real estate in the world is on the coasts. People like living in temperate areas next to the water; and historically these areas were more accessible by sea, and were settled first. With a more concentrated population and higher demand, the real estate costs more. Therefore, most property insurance companies are over-allocated to coastal real estate from a value perspective. The property insurance market has a solution for this as well: it’s called reinsurance.
Reinsurance, in a basic sense, is when insurance companies take their insurance, and insure it. Insurance squared. Let’s say an insurance company sells a policy on a condo in Miami, an area vulnerable to hurricanes, they will then go and buy insurance on the insurance policy they provided so that in a worst-case scenario, their out-of-pocket expense is buffered. As a result, property insurance between high climate-risk coastal areas and lower climate-risk inland areas becomes crossed in a big pool that’s financially connected; to the tune of over $1 trillion.
When events like those that transpired in Acapulco happen, the cost of reinsurance goes up, which causes the cost of property insurance to go up on all real estate.
Let’s talk numbers. Is the impact on real estate values significant? Short answer: yes
The Vice President of Risk at a major REIT helped quantify the tangible impact of this on a real estate portfolio. First, she confirmed that nearly all CAT insurance is reinsured to some extent. In 2023, due to several outlier CAT events globally, such as the events in Acapulco, carriers are seeing 50% increases in their reinsurance costs.
Those carriers, in turn, passed that cost along to the real estate companies whose property they insure. At this particular REIT, 2023 same-store increases on insurance costs were 25% across their portfolio. Is this a lot? Well, compared to the same REIT’s 2022 same-store insurance increase of 5%, it’s a 5x greater increase. This expert added that the 2022 increase of 5% was already historically high. Therefore the increase in insurance cost due to adjustments in reinsurance is significant, with the next natural question being: how does this impact real estate values overall?
Using an illustrative contemplated $100M investment in a residential building, increasing year 1 forecasted insurance costs from 5% to 25% over baseline impacts the deal by about 5 bps on a cap rate basis. In human words, due to the cashflow impact in year 1, the $100M property is now worth about $99.5M, or half a million dollars less. If we extrapolate the increase in insurance cost to all years, the impact becomes even more significant.
Even still, this may not seem like much on percentage terms, but consider this. Most estimates place the value of all professionally managed real estate at ~$20 trillion. The loss in value due to increased reinsurance costs, if evenly distributed across all assets, would be $100B. This is, of course, if assets were fairly marked to market in real time which as we know in the real estate industry, they are not. If you don’t know what this means, I explain it in layman’s terms in the first edition of
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Other downstream impacts, and the future of climate risk
This analysis is admittedly deeply theoretical and simplistic. In the real world, other practical solutions are often introduced: such as new insurance products or business models. However these may not always be ideal either.
For example, companies in the reinsurance market might increase their “attachment point”, which is the threshold under which the reinsurer is not responsible for damages. Once the loss exceeds this amount, the reinsurer will step in and pay for the excess. On most professionally managed residential properties, there is a $50M attachment point, but reinsurance companies have now increased this number in some cases.
In other cases, the reinsurance market might simply not cover a policy at all. For example, if a property is in a high climate-risk coastal area there might be no reinsurance available. That, in turn, places more risk on the property insurance companies’ books; and in some cases, the property might become uninsurable altogether. What happens if the most valuable real estate in the world, found in coastal areas, becomes uninsurable? The cost of owning these properties, which now have to be self-insured, goes up. Catastrophic events happen with regular frequency. If a coastal property is “totaled”, for lack of a better term, every 10 years by an earthquake or a hurricane then suddenly an owner or a potential owner has to write off the entire property’s value over a 10-year hold period. That’s a daunting reality to underwrite as a real estate investor.
In this spiral, coastal real estate becomes non-viable very quickly, and suddenly inland areas become more valuable.