Homes in areas that are vulnerable to flooding are overvalued by $121–$237 billion, finds a new study coauthored by RFF Fellow Yanjun (Penny) Liao. In this blog post, Liao examines the implications for households, communities, and policymakers.
Late last September, Hurricane Ian struck the west coast of Florida. Surges from the Gulf of Mexico and heavy rainfall contributed to widespread flooding; according to one estimate, the National Flood Insurance Program could lose $10 billion in payouts for insured flooding damages.
Other recent extreme weather events, such as the deluge in Appalachia over the summer and the so-called “bomb cyclone” in California in January, also have caused major flooding, forcing residents to evacuate and damaging or destroying homes.
Although analysts expect the effects of climate change to increase the risk of such flooding for US households, housing markets may not be accounting for flood risk. According to a new study, homes located in flood zones are overvalued by $121–$237 billion.
Study coauthor Yanjun (Penny) Liao, a fellow at Resources for the Future (RFF), shares her expertise about the causes of this overvaluation; whom the overvaluation most affects; and the implications for homeowners, local and state governments, and the federal government.
Resources: Why are home prices overvalued in areas that are at high risk of flooding?
Yanjun (Penny) Liao: At the most basic level, home prices are overvalued in risky areas because people do not fully factor in the expected cost of flood damage to risky properties when they’re making the decision to purchase a home. This implicit underestimation of risk by home buyers could be due to various reasons. For example, people might not be fully informed of the risk, or they may have trouble understanding the information about the risks. People might expect that the government will step in and provide aid after a flood, or they might expect the government to build flood-protection infrastructure that will lower their risk in the future. Many homeowners get flood insurance from the National Flood Insurance Program that ends up being too low to cover their expected losses.
When people have a mortgage, part of the risk is borne by the lenders or entities that guarantee the loan—and not on homeowners.
If the prices of overvalued homes suddenly decreased to more accurately account for flood risk, what implications would we expect to see? In other words, what would happen if the flood-risk housing bubble burst?
A sudden drop in housing values would have major implications for both homeowners and local governments.
For the average household, home equity is their most important source of wealth, so a sudden depreciation would affect their financial health and welfare going forward. A drop in housing values also would make it harder for a household to move and get housing elsewhere, since they would earn less by selling their current house.
For local governments, housing value depreciation erodes their property tax base and makes it more difficult for them to maintain a balanced budget in the short run. This blow to the budget might mean that the local government would need to cut back on spending or draw on their reserve funds. In some cases, this loss in the tax base also might impact the borrowing ability of local governments, as lenders become more reluctant to offer loans at a low rate, given the weakened revenue sources.
Where are overvalued properties most concentrated? If housing prices get adjusted to reflect flood risk, who would be at a disadvantage? Who might stand to benefit?
If we are looking at overvaluation as a fraction of property values, we find that the overvaluation is concentrated in Appalachia, northern New England, and many counties along the Gulf and Atlantic Coasts. At the individual level, homeowners of overvalued properties in Appalachia might have a larger share of their housing wealth impacted.
Local governments that rely heavily on property taxes for revenues are particularly vulnerable to the fiscal consequences. While several municipalities scattered along the coasts fall into this category, we find that many of the examples actually would be inland municipalities in northern New England, the Midwest, eastern Tennessee, central Texas, and Idaho.
It’s conceivable that safer locations may stand to gain as people migrate to those places and housing values there appreciate. But at this point, projecting any benefits remains speculative.
If developers, real estate groups, and policymakers want to avoid overvaluing properties that have flood liability, how can those stakeholders communicate flood risk more effectively?
First, we should make sure that accurate information is available and accessible to homeowners and potential home buyers. Many states still do not require information such as the home’s flood zone or history to be disclosed to potential buyers, and evidence (including the results we’ve just published) suggests that sharing flood information makes a difference in how risk factors into housing prices. Researchers in behavioral economics and cognitive science have studied how information about probability can be conveyed in a way that’s easier for people to digest. For example, a 1 percent chance of flooding per year is the same as a 26 percent chance of flooding during the lifetime of a 30-year mortgage. It is important for any outreach effort to figure out the best messaging.
More importantly, we need to have institutions and systems that provide the right price signal about risk. People make economic decisions all the time, and understanding the ramifications of flood risk is easier for people if weighing that risk is an economic consideration. To that end, insurance needs to be priced to reflect expected risk—which is what the Federal Emergency Management Agency’s current Risk Rating 2.0 effort aims to do.
If they want to rectify these issues and mitigate risks for all involved, lenders and government-sponsored enterprises that back mortgages need to consider stronger requirements for borrowers to hold flood insurance—even for properties outside of the Special Flood Hazard Areas (100-year flood plains). These borrowers are not subject to any mandate to buy insurance at the moment, but they too are at risk and account for a large share of the overvaluation.