Why flooding can affect value
The basic issue
Flooding causes significant disruption and damage, both to businesses, properties and people, even if the flood waters are not that deep. The fear that flooding might affect a property can be a powerful factor in the decision to buy or rent it. With one in six properties at risk of flooding, and over half of those at risk of surface water flooding, (Environment Agency, June 2009) it is important to know whether you are about to acquire or lend on such a property.
It has only been possible for the public (and lenders) to access robust information on potential surface water risk since approximately 2011. The Environment Agency have some surface water data, which they supply to Lead Local Flood Authorities, but do not yet make it available through their free on-line Flood Map. This contrasts with the information that they do make available on river and coastal flood risk (and which is usually captured by the due diligence required by lenders).
The lender’s perspective
If a lender’s security turns out to be worth less than they expected, the lender may be exposed, should the borrower default and they have to realise that security. So lenders should consider seriously whether to expand their due diligence so that they access the full picture on flood risk. This can be done at very modest cost, which can often be passed down to the borrower (as with other search fees). If your solicitor has not yet discussed this with you, it may be wise to ask them whether the time has come to add it to your conditions precedent or standing instructions to panel firms. Since the Law Society issued its practice note on flooding issues in May 2013, lenders may find that their panel firms raise with them the question of whether a flood risk search should be done.
Benefit to the borrower
Although true that such a search will help to protect the lender, there is significant benefit in it for the borrower. The government is very keen that all buyers should know their flood risk. One of the central recommendations of the Pitt Report into the 2007 flooding was that a flood search should become standard practice. The work done by the working parties set up by the Flood Summit in Autumn 2010 (a collaboration between the government, the Environment Agency, the insurance industry and several other stakeholders) demonstrates total agreement that the public need to become more aware. This was reported at a meeting convened by Department for Environment, Food and Rural Affairs (Defra) on 19 July 2011.
Why has this not been an issue before?
We used to ignore this
Conventionally, home owners, businesses and lenders have turned a blind eye to all but the highest levels of flood risk. Unless there has been a recent episode of active flooding, they tend to assume that it will not happen again in their period of ownership; that, if it did, their home and contents insurance will put things right; and that, anyway, it is the responsibility of the government (either central or local) to improve flood defences.
Why we should not continue to do so
This reasons for ignoring flood risk were always somewhat flawed, but are all the more so now because:
- The market for flood risk has been undergoing significant change. Insurance is likely to become steadily more expensive for properties at risk, and full insurance may be unavailable for those at highest risk.
- Even where insurance is available and affordable, it does not sort out all the consequences of flooding. Nor does it resolve things quickly. Homeowners may be out of their property for many months, irreplaceable belongings will be lost, and some businesses may not survive the disruption. Astute buyers will know this, and may factor the risk of it into the price they pay for a property at risk.
- Planning policy now pays more careful regard to the flood risk which new developments may be exposed to, or cause. Development sites may become more difficult to exploit, or require more to be spent on flood protection measures, and be less valuable as a result.
- The government has less to spend on flood protection measures. It is moving to a “payment for outcomes” model, where local residents and businesses (who see benefits in new flood protection measures) join with the government (through local authorities or the Environment Agency) to fund improvements in flood protection.
- It is possible to make changes to a property which will reduce the impact of flooding. Knowledge of what is feasible and cost effective is improving all the time. The insurance industry is beginning to take note of such measures when deciding whether to offer flood insurance, and on what terms. So discovering there is a risk does not necessarily mean the property is blighted.
- Whatever your views on climate change, there is certainly evidence that weather patterns, and in particular rainfall, are changing. Much of the surface water flooding in 2012 resulted from rainfall quantities which were predicted to occur only once every 200 years.
How flood risk insurance is changing
This is still a moving target, but what is absolutely clear is that the insurance industry would prefer to adopt a true risk-based pricing structure in which each insurer would decide for itself which types of property it wants to insure against flood, and how much it will want to charge (based on its assessment of the potential for claims, and the size of those claims).
Lenders may not realise, but at least for most small businesses and home owners, this risk-based model does not fully apply at the moment. As a result, the premiums for high risk property are subsidised by those for other properties. The 2008 ABI Statement of Principles encourages this. The Statement of Principles is due to be replaced, but has been extended (beyond its original expiry in June 2013) to cover the period until the replacement scheme has been developed.
The preferred replacement is called Flood Re, but there are several issues still to be resolved (October 2013) before this scheme can be implemented. Even if successful, it will only cover some kinds of domestic property. For all other properties the availability of flood insurance and its cost will be governed by the open market.
Surface water risk is now known
Alongside the move to a risk-based model, many insurers (for example Aviva and AXA) purchase surface water flood risk data. Some also buy data about other types of flooding, such as that from overflowing sewers, or ground water, or from reservoirs or dams, were they to be breached. Insurers use that data in different ways, but the important fact is that they have access to it and can factor the risk of those types of flooding into the price of their insurance cover.
This is likely to mean that properties, both business and residential, that are in areas which insurers think are at greater risk of flooding (and each may set its benchmark in a different place), will be charged more for their flood cover. Some may also suffer from a higher excess, or find that conditions are placed on the policy requiring flood protection measures to be taken if cover is to be maintained.
Affordability not availability of insurance
It is unlikely that many property owners or tenants will find themselves unable to get flood cover. Even the very high risk properties will probably find an insurer that is willing to offer cover, but it will come at a price. So the issue will become affordability not availability of insurance. This is confirmed in the Defra report in December 2011.
Buyers may be put off by the increased cost and conditions on the insurance that they may face, or may offer less for the property so that they have some cash to meet those costs. This is where the insurance issue impacts on value directly.
Policing the borrower
As flood insurance becomes more expensive for properties at risk, Lenders will need to be more vigilant in checking that their borrowers do maintain comprehensive buildings insurance (including flood cover) as required by the terms of most loans, despite the additional cost.
Will block insurance policies alleviate the risk to value?
The simple answer is not necessarily. Even if the current owner (for example a pension fund or property company) can obtain insurance at standard rates for a property at flood risk, as part of a much larger diverse portfolio covered by a block policy, that does not mean its buyer will be able to do the same. If the property is sold (rather than the portfolio) the buyer may well be a much smaller concern, whose insurer will not offer block cover without a loading for the flood-risk property. So the immediate owner may not have a problem, but the potential for a value hit on disposal is still there.
How to find out about flood risk of all varieties
Some information on coastal and river flood risk can be obtained free from the Environment Agency website, but that information is not enough on its own. Moreover there are several drawbacks to the way that information is presented, and the degree of refinement in the data. For example, it cannot predict the depth of potential flooding and it cannot distinguish between the individual properties within a risk area.
So that information should be supplemented with at least a desktop flood search. A good one will pull together the following:
- Information on coastal and river flood risk that is of a better standard than that available from the Environment Agency.
- Information on surface water flood risk, including its likely depth (since the cost of repairs, and the measures to keep the water out, differ considerably with the depth of water).
- Information on other, less frequent, types of flooding (from ground water, sewers which are inadequate or faulty, dams or reservoirs).
- An assessment (by a qualified specialist) on whether the overall picture presented by that information represents a low, medium or high overall risk of flooding. It is little use to a lender, or borrower, or their respective solicitors, to be given a mass of data with no interpretation.
Currently (October 2013) the VAT exclusive cost of such a search is around £20-£30 for a residential property and around £75-£150 for a commercial property, though bigger properties will cost more. This is a very modest cost, in comparison with the overall price of the property and the amount being advanced on it. Turnround times are very fast – one to two days being the average.
There are several reputable providers of such desktop searches. If the lender wants more information on the risk exposed by the result, those providers usually offer a more extensive search report, and some will offer advice on the flood protection measures that could be worthwhile. Armed with the information and their assessment, some search providers may even be willing to assist in persuading insurers that they should offer cover, or reduce the cost.
Forewarned is forearmed. If a lender wants to be sure that its security value will not be adversely affected by a subsequently exposed risk of flooding, it needs to expand its due diligence procedures now. Just because we have not tended to worry about flood risk in the past does not mean we should continue to bury our heads in the sand.
Article written by Practical Law Company