In addition to the natural risks, constructions costs have risen sharply, due in large part to the price of building materials. Lingering COVID-era supply issues along with overall inflation have driven costs up, translating to higher property replacement costs, which directly impact the Total Insurable Value from which the premium is derived.

Compounding these dynamics are the distinct migration patterns in the United States over the last few years. The broader adoption of work-from-home propelled by COVID has, among other factors, brought significant population growth and new development to geographies intersected by the path of these weather events.

A further piece to the insurance puzzle is the role of reinsurance, or insurance for insurance companies. Jason Kjellson, Executive Vice President, Capital Markets, Crew Enterprises (formerly Versity Invest), notes, “It is not possible to overstate the importance of the reinsurer in the conversation of insurance rates for U.S. commercial real estate. All of these factors drive the appetite of global reinsurers to allow or expand reinsurance for markets based on the factors affecting any individual market.” He adds, “Events that happen on the other side of the planet can have an impact on the rates you pay locally for your fourplex as insurers and reinsurers look to offset losses globally. More natural disasters happening in more densely populated areas during inflationary periods is a perfect storm.”

This unique confluence of events and the degree and pace to which they have affected the insurance market has challenged otherwise well-performing assets and, in some cases, resulted in temporary reductions of cash flows, including for some DST properties.

Certain characteristics and strategies, however, may make DST assets particularly well-positioned to mitigate these effects in the long term.

Absorbing the Insurance Impact: DST Characteristics and Strategies

Economies of Scale

Among the advantages of a DST investment is the built-in professional management of sponsors who commonly have many thousands of units under management. The economies of scale this affords is advantageous in procuring favorable insurance policies, which may be strategically designed to include a larger portfolio of assets across various geographies, offering risk diversification for insurers and leverage in negotiating new policies.

Dallas Whitaker, CEO, Carter Exchange shared on the subject, “Overall, the larger the portfolio, the more leverage there is with carriers and the more creative one can be with designing the insurance program. Aggregating assets can have a leveraging effect on the market and allow for broader terms and reduced costs.” However, he also noted, “This does have some risk associated with it as there is a greater possibility for loss with a greater number of assets on a program.”

Capital Square’s insurance team concurs that such umbrella policies offer a significant benefit with sponsors that have scale. Whitson Huffman, Co-Chief Executive Officer, Capital Square, adds, “There are many benefits to spreading risk across a large portfolio that has a variety of asset classes and geographies. While no one is immune to the recent impact of insurance markets, scale is a big mitigating factor when structuring a portfolio-wide insurance program with diversification that can provide flexibility to cover specific risks that would otherwise be extremely difficult and costly to cover.”

Procurement

Much goes into designing and negotiating new policies, especially those that take advantage of this aggregation strategy. Passco, as part of their policy procurement and renewal negotiation process, routinely vet the insurance brokers whom they engage to ensure they are most adept at negotiating favorable terms. Additionally, they retain a third-party risk management consultant to confirm that the outside broker is securing the best policy, coverage, and premium available. This analysis can take place at the individual property level or, as in Passco’s case, on a master insurance program for a broad portfolio of properties, offering potentially more advantageous terms. Given the numerous properties in their portfolio, policy renewals come up on a rolling basis, which keeps Passco continually involved in the negotiation process.

Capital Square has its own insurance program and an asset management team that is heavily involved in negotiating insurance coverage and premiums. In 2023, they launched Capital Square Living to bring their apartment property management in-house. Among other advantages, Whitson notes, “This is a favorable approach over relying on third-party property managers who may not have the landlord’s best interest. A third-party management company’s policy can be valuable in certain scenarios, but that comes with a lack of transparency and often a fee for providing program access. This provides further benefits as we have better data and oversight of ongoing maintenance and preventative measures that can help craft an elevated story when shopping for property coverage.” As part of that procurement process, Capital Square utilizes services of Marsh & McLennan Agency, the largest insurance broker in the world. Whitson asserts, “This ensures we have knowledge and access to nearly all possible coverage solutions available in the market.”

Institutional Quality Properties

The institutional quality of DST properties is also an important factor in their capacity to absorb increased expenses. Multifamily DST assets are often large, best-in-class properties with relatively high household incomes among the renter population, providing both scale and elasticity to raise rents to cover increased costs.

Capital Square’s insurance team shares that with larger properties there will be a larger coverage stack with potentially multiple insurance carriers participating, allowing them to take only the risk exposure in the coverage stack that they are seeking. This creates more efficiency and lower prices for property owners. Furthermore, large scale properties are also eligible for access to a broader market of insurers, providing a more competitive pricing environment. “Generally, there is more capacity for a 300-unit apartment property than a duplex. Similarly, there is more capacity to insure a $100M apartment property than a $1M property. Also, insurers use a metric called Maximum Probable Loss when determining premium rates at different levels of the coverage stack. The first dollars are always more expensive to cover. The $1M property likely has a higher premium rate per $100 of value than the $100M property. This is because the probability of a total loss is greater for a smaller property ($1m or duplex) versus a larger property ($100M or 300 units),” Whitson added.

In addition to the important role of property size in the equation, the quality of these Class-A properties is also favorable. “Well located and amenitized quality properties offer the best prospects to maximize rent increases over time, which helps to offset increases in operating expenses, including insurance costs,” said Dallas.

Capital Square notes that on top of this greater elasticity, the particular resident demographic commanded at best-in-class properties typically results in less general liability claims, helping keep that portion of premiums down. “On the property coverage side, these demographics generally also result in less accidents (a resident causing a fire) and a higher propensity to have tenant legal liability, which would cover first dollars (typically $100K) in the event of such a loss. We typically see a large delta in average household income even when comparing our Class-A and Class-B properties. That delta can be as much as $100K average annual household income for a Class-A property to $60K at a Class-B asset and can lead to a meaningful decrease in premiums per unit for Best-in-Class assets,” said Whitson.

Perhaps of greater significance than anything else is the better construction attributes of the new, best-in-class communities. “There are many examples where this applies, a simple one being a fully sprinklered property versus an older property that does not have sprinklers”.

Reserves

As a short-term strategy, reserves included as part of the DST syndication may be accessed in the event of unexpected events, such as the recent sharp rise in insurance costs. “Reserves can be built in to offset higher premiums or could be used to take higher deductibles and have available reserves to pay deductible costs that occur during the year,” said Dallas.

While reserves are included to cover capital needs and unforeseen events at a property and would not typically be used for operating expenses, Capital Square adds, “The significant premium increases in 2023 necessitated a look at all available funds to stabilize property-level cash flows. It is beneficial that DSTs provide this source of built-in reserves that can be utilized over a brief period to manage unusual expenses and maintain operations at a property.”

Fee Reductions

In reaction to or anticipation of these kinds of market changes, DST sponsors may also elect to reduce various fees, such as asset management and disposition fees, which may recoup some of the increased insurance costs. Speaking to Carter’s use of this strategy, Dallas said, “Carter Exchange recognized in early 2023 the overall market challenges and took steps to benefit investors through decreased asset management, acquisition and managing broker dealer fees, and implemented other cost saving measures, collectively resulting in over $16 million of savings for investors.”

Looking Ahead

In the 12 months ending January 2024, property insurance rose 27.7% year-over-year nationally, according to real estate research firm Yardi Matrix, based on reporting from 22,000 multifamily properties. Indications are that following this dramatic increase, insurance carriers are beginning to return to profitability as they adapt to the new reality4.

“2023 was a reset year for insurers who adjusted terms and property valuations to help expedite a return to profitability after a disastrous 2022,” said Whitson, also noting that capacity returning to the industry will help stabilize the market, proving true thus far in 2024 projecting to be a softer market than in recent years.

The 2024 US Property and Casualty Outlook from Swiss Re puts a figure on it, “expect(ing) rate growth in the high single digits, and liability rate growth in the low single digits, on average” in 20243. Referencing this report, Jason Kjelson summarizes, “Rate increases are expected to persist in 2024, albeit not at levels seen for the last few years… This should be music to the ears of commercial property owners.”

While inflation-driven expense growth persists, so too has net operating income (NOI) growth. “Matrix found that profitability at multifamily properties in the period studied was up in the 12 months ending January 2024 because gross income rose more than expenses. Nationally, the average annual gross income per unit increased $1,056, while expenses rose by $593, translating into a $463 increase in net operating income (NOI)4.”

With this in view, properties that have largely weathered the insurance storm following what has been a historically hard insurance market may be better positioned going forward as insurers move back into the market and more stable conditions lie ahead. As costs stabilize, DST properties with their various key attributes may be well-suited to mitigate the current impacts and rebound to higher profitability.

Even with indications of a return to a more normal insurance environment in view, Cornerstone is remaining proactive to monitor this issue, share coping strategies across the industry, and keep our clients informed of the latest developments.

“Facts + Statistics: Hurricanes,” Insurance Information Institute, https://www.iii.org/fact-statistic/facts-statistics-hurricanes – Accessed March 27, 2024.
“Billion-Dollar Weather and Climate Disasters,” National Centers for Environmental Education, https://www.ncei.noaa.gov/access/billions/ – Accessed March 27, 2024.
“US Property & Casualty outlook: strong momentum into 2024, led by personal lines,” Swiss Re Institute, https://www.swissre.com/institute/research/sigma-research/Insurance-Monitoring/us-property-casualty-outlook-january-2024.html – Accessed March 27, 2024.
“Expense Growth Bedevils Multifamily Properties,” Yardi Matrix.

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